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90–930 PDF 2004

S. HRG. 108–232

FEDERAL RESERVE’S FIRST MONETARY POLICY

REPORT FOR 2003

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

ON

OVERSIGHT ON THE MONETARY POLICY REPORT TO CONGRESS PURSUANT TO THE FULL EMPLOYMENT AND BALANCED GROWTH ACT OF 1978

FEBRUARY 11, 2003

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

LINCOLN D. CHAFEE, Rhode Island

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

PEGGY R. KUHN, Senior Financial Economist

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

MARTIN J. GRUENBERG, Democratic Senior Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

CONTENTS

TUESDAY, FEBRUARY 11, 2003

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Dodd .................................................................................................... 2

Senator Allard ................................................................................................... 4

Senator Reed ..................................................................................................... 4

Senator Bunning ............................................................................................... 5

Senator Schumer .............................................................................................. 6

Senator Sununu ................................................................................................ 6

Senator Bayh .................................................................................................... 7

Senator Dole ...................................................................................................... 7

Prepared statement ................................................................................... 44

Senator Miller ................................................................................................... 7

Senator Crapo ................................................................................................... 7

Senator Carper ................................................................................................. 8

Senator Sarbanes .............................................................................................. 9

Prepared statement ................................................................................... 44

Senator Johnson ............................................................................................... 11

Prepared statement ................................................................................... 45

Senator Corzine ................................................................................................ 13

Senator Stabenow ............................................................................................. 39

WITNESS

Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, Washington, DC ........................................................................................... 13

Prepared statement .......................................................................................... 46

Response to written questions of:

Senator Shelby ........................................................................................... 52

Senator Reed .............................................................................................. 60

Senator Bunning ....................................................................................... 63

Senator Miller ............................................................................................ 64

Senator Crapo ............................................................................................ 65

Senator Sarbanes ...................................................................................... 68

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Monetary Policy Report to the Congress, February 11, 2003 .............................. 70

(III)

(1)

FEDERAL RESERVE’S FIRST MONETARY

POLICY REPORT FOR 2003

TUESDAY, FEBRUARY 11, 2003

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10:15 a.m., in room SH–216 of the Hart

Senate Office Building, Senator Richard C. Shelby (Chairman of

the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing will come to order.

I believe we have a quorum. Since we have a quorum present,

I would ask that the Committee favorably report the nomination of

William Donaldson, to be a Member of the Securities and Exchange

Commission for the remainder of the term expiring June 5, 2007.

Can we do a voice vote?

Senator DODD. I second the nomination on that, Mr. Chairman.

Chairman SHELBY. The nomination has been seconded by Senator Dodd. All in favor, say aye.

[A chorus of ayes.]

Chairman SHELBY. All opposed, no.

[No response.]

Chairman SHELBY. The ayes have it.

The nomination is favorably reported. We will leave the record

open so that any Member who is not present will have an opportunity to record their votes, if they care to.

I am very pleased this morning to welcome Chairman Greenspan

before the Committee on Banking, Housing, and Urban Affairs, to

testify on the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress.

Chairman Greenspan, our Nation’s economy appears to be highly

resilient. Last year, accounting scandals and corporate misdeeds

unnerved investors and weakened trust in financial markets. The

war on terrorism and our continuing efforts to enhance homeland

security consumed valuable resources, but are necessary to preserve long-term security and freedom.

Despite these challenges, the economy grew at a 2.8 percent pace

in 2002, with inflation remaining low at only 1.3 percent. Productivity growth was more impressive. On an annual average basis,

productivity in both the business and nonfarm business sectors

rose 4.7 percent in 2002—the fastest pace since 1950, and more

than four times the 1.1 percent gain posted in 2001. On the unemployment front, the unemployment rate decreased to 5.7 percent in

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January, falling three-tenths of a percentage point from December’s

6.0 percent, and hit its lowest level since September 2002.

On the economic front, consumers continue to be a source of

strength to this economy. Many homeowners have benefited from

record low interest rates as they purchase new homes and refinance mortgages. Residential investment remains strong, but business investment continues to be weak. This is certainly a source of

concern as we look to businesses to purchase new equipment and

hire new workers.

I believe that ending the double tax on corporate income and permanently raising expensing limits for small firms would stimulate

more of this needed investment. While it would be very difficult to

repeat the productivity gains of this past year, we need to continue

to focus on what can be done to further grow the economy, to improve productivity, and ultimately the standard of living for all our

workers.

This requires that we look to our fiscal policy for improvement.

I believe the President has put forward a very thoughtful, targeted,

and balanced plan that would not only stimulate the economy in

the short term, but make very positive long-term policy changes

that would sustain strong economic growth.

But just as vital to our success in achieving these goals is the

underlying credibility and integrity of our capital markets.

Earlier this morning, just a few minutes ago, this Committee

voted to send forward the nomination of William Donaldson to

chair the Securities and Exchange Commission. I believe he has

the stature and the experience to provide the strong leadership

that will be necessary to help set the tone for the high standards

of corporate governance and financial reporting that our markets

demand.

Mr. Chairman, we are pleased to have you with us this morning,

and we look forward to you discussing with us the necessary actions we must take to ensure that our economy grows and prospers

in the coming years. I look forward to hearing your remarks.

Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Mr. Chairman, Senator Sarbanes, I am sure, will

be along shortly. Let me make a couple of opening comments, and

then leave the record open for Senator Sarbanes to add his

thoughts as well.

First of all, Mr. Chairman, we welcome you once again before

this Committee to discuss the Federal Reserve’s Monetary Policy

and the state of the economy. It is always a pleasure to have you

here before us.

Since you last appeared before the Committee, Mr. Chairman,

the unemployment rate has lingered near 6 percent and the stock

market continues to tumble. Consumer confidence levels remain

low and economic growth has been reduced to a near stand-still, at

0.07 percent. All this, in addition to the looming war and rising oil

prices, has led some analysts to continue to express concern that

we may see a double-dip recession.

When President Bush took office, the Nation was in the midst of

its fourth consecutive year of budget surpluses. Both the CongresVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 90930.TXT SBANK4 PsN: SBANK4
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sional Budget Office and the Office of Management and Budget

projected surpluses of more than $5.6 trillion over fiscal years 2002

through 2011.

At that time, the President submitted his first budget 2 years

ago and he promised that the Nation could afford to use projected

surpluses to pay for his $1.3 trillion tax cut, and still have enough

to meet our spending needs in the Nation. I believe he was wrong.

His tax cuts have brought about soaring deficits and instead of trying to decrease the deficit, the President continues to add to it.

Last week, President Bush submitted his fiscal year 2004 budget

proposal to Congress, which substantiates how much the economy

has deteriorated during his first 2 years in office.

In the Bush Administration’s first budget, it projected a 2004 surplus of $262 billion. In his second budget, a year ago, the Administration projected a $14 billion deficit for the year 2004. And

now the budget for fiscal year 2004 projects a record deficit of $304

billion this year and $307 billion next year.

During President Clinton’s last year in office, we were looking at record surpluses of $236 billion. This is the swiftest fiscal deterioration our Nation has seen in its history. This is even worse than

the record deficit set by President Bush’s father.

Even though the numbers show that the President’s previous

economic policies hurt the economy, this year’s budget contains

much of the same centerpieces as the first budget demonstrated—

tax cuts for some of the wealthiest Americans. This year’s proposed

tax cuts will cost $1.3 trillion.

I see, by the way, my colleague from Maryland has arrived.

Just yesterday, more than 10 Nobel Laureates, together with 450

respected economists from universities and institutes from all

across the Nation signed a statement expressing caution that the

tax cut plan proposed by the President will not only fail to help the

economy in the short run, but also will weaken it over the long

term by enlarging projected deficits.

Any growth package, of course, that Congress passes should go

to the people who most feel the ills of the economy. After all, since

before President Truman, no President has presided over an economy registering net job loss until now.

Since President Bush took office, the economy has lost 2.3 million

private-sector jobs, averaging about 75,000 jobs lost a month. In

contrast to the previous Administration, we saw the creation of

239,000 jobs gained per month.

In 2001, it was projected that we would be debt-free by 2008. The

Congressional Budget Office now forecasts that the Nation’s publicly held debt will skyrocket to close to $4 trillion.

History has shown us that if we ignore fiscal discipline, the debt

continues to increase and we will see high long-term interest rates

and lower productivity growth. Businesses will be less likely to invest and spend.

Chairman Greenspan himself has said this throughout the years.

Mr. Chairman, these are trying times both home and abroad. But

the decisions we make on the economy today will have long-lasting

implications for all of us, and generations to come hereafter.

We need to understand that circumstances have changed profoundly. Our surpluses have turned into deficits. We are seeing a

4

record number of job losses. Our economy’s growth rate has been

the slowest in 50 years. The Dow and NASDAQ stock markets have

lost roughly $5 trillion in market value.

It would be foolish for anyone to think that our policies should

not change in response to these circumstances. It is unfortunate

that thus far the Administration, in my view, has failed to see this.

So, Mr. Chairman, we look forward to hearing from you this

morning to talk about what can be done to change the direction

that we presently seem to be heading in.

Chairman SHELBY. Senator Allard.

COMMENTS OF SENATOR WAYNE ALLARD

Senator ALLARD. Thank you, Mr. Chairman, for holding this

hearing. I would like to join you in welcoming Chairman Greenspan before this Committee again. It is always a delight to hear his

comments as we move forward with the next Congressional session.

I happen to feel that when the President assumed office, the

economy was beginning to head in the wrong direction. It was

headed in a negative direction. And I believe now, that the economy is beginning to head back in a positive direction.

I want to thank Chairman Greenspan for his efforts to get us on

the right track.

Yet, the American economy still has some elements of uncertainty. But I still believe it is critical that the Congress move to

address the long-term solvency of Social Security and Medicare, to

put the Government on a plan to pay down the national debt, and

to continue to cut taxes. I believe by pursuing policies of low taxation, limited Federal regulation, free trade, and monetary policy,

the United States will experience great wealth and opportunity. We

will create new jobs.

I believe that we should follow these policies of limited Government. And Chairman Greenspan, having shared a few of my

thoughts with you, I now look forward to your comments.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Thank you very much, Mr. Chairman. And thank

you, Chairman Greenspan, for joining us.

I would like to associate myself with Senator Dodd’s comments.

I thought he was quite eloquent in his discussion of the current

economic situation. Like him, I am afraid that the fiscal discipline

of the 1990’s is a fading memory and we are headed for a repeat

of the fiscal mistakes of the 1980’s.

The 1980 tax cuts were a mistake at that time, but similar policies would be an even greater mistake now. At least in the 1980’s,

the pressures on the budget from the retirement of the baby-boom

generation were off in the relatively distant future and there was

time to restore fiscal discipline.

This time, however, the biggest tax cuts will be kicking in at just

about the same time that the baby boomers start retiring and start

claiming the Social Security benefits that they have contributed

and the Medicare they expect.

5

There is a fundamental question that we have to address—is this

Government going to break its commitments to the beneficiaries of

Social Security who have contributed to the system and to American citizens who reasonably expect that their health bills will be

paid by Medicare?

Also, we have a commitment to fund an ongoing war against terrorism and perhaps other military operations, a commitment I do

not think anyone around this table, and Chairman Greenspan

would say, we will not fulfill totally.

With the context of Social Security, Medicare, and expenditures

for war, we have to be concerned about the proposed tax cuts,

which are I think both unwise and unfair.

Indeed, one of the economists today who associated himself with

the hundred other economists in the United States, including several Nobel Prize Winners, indicated that the President’s tax plans

are a weapon of mass destruction aimed at the middle class.

I think we have to be cognizant of those types of comments and

recognize and understand that the policies being advanced today by

the President will not help restore our economy, nor will they help

us face the responsibilities to fund Social Security, Medicare, and

to conduct an international war against terrorists.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. Thank you, Mr. Chairman.

I would like to thank you for holding the hearing, and I would

like to thank Chairman Greenspan for coming before the Committee today.

As we all know, and as has been said before, our Nation’s economy has been sputtering. We had good growth in the first quarter

of last year. We had weak growth in the second quarter. We had

good growth again in the third quarter. And we had almost no

growth at all in the fourth quarter.

Seasonally adjusted unemployment was down in January, after

a sharp rise in December. The stock market was up and now on

the uncertainty of a possible war, it is down. Energy prices are up,

but interest rates are still low.

As I have pointed out many times, I believe that you waited too

long to cut the Federal funds rate when the economy started

tanking in 2000. I believe that delay has greatly contributed to the

state of our economy right now. Unfortunately, we do not have a

time machine to fix past mistakes. You did aggressively cut rates

to try to help right the economy, so much so that it is pretty difficult to cut much more. Unfortunately, it was late in the game.

Hopefully, you will have some good news for us today. The American people still do not have strong confidence in this economy.

They may see a light at the end of the tunnel, but they still think

it might be a train.

Your words matter, Chairman Greenspan, maybe more than they

should. But they still matter.

You make statements on fiscal policy, which you should not be

doing. I understand that sometimes making statements, you believe you are off the record, and your comments about the PresiVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 90930.TXT SBANK4 PsN: SBANK4
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dent’s economic plan may have been taken out of context. But this

is Washington. Every microphone is ‘‘wired and hot.’’

You have been in this town for a long time. Some might say too

long. You know ‘‘how to play the game’’ and you have played it

well. If you are innocent and if the statement you made about the

President’s plan were off the record and out of context, you should

have known better.

If it was neither off the record, nor out of context, then you are

once again interjecting yourself into matters where you have no

business. Like you, I believe the Federal Reserve should be fiercely

independent. No President should try and set monetary policy.

That is not his job.

But the Fed Chairman should not try to set fiscal policy. That

is not your job. It is a two-way street. I understand you are asking

questions about fiscal policy. I am sure you will be asked some fiscal policy questions at this hearing, and you should answer them

truthfully. But just as the President should not undermine you on

monetary policy, you should not undermine him or Congress on fiscal policy.

Once again, thank you, Mr. Chairman, for holding this hearing.

Thank you, Chairman Greenspan, for running the gauntlet

today. I look forward to talking with you further during the question and answer period.

Chairman SHELBY. Senator Schumer.

COMMENTS OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman.

I want to thank Chairman Greenspan for being with us because

I believe that there is no more respected economist in the world,

and we greatly value your time and perspective.

Seeing Chairman Greenspan here today makes me think of the

classic Yogi Berra line, it is like de ́ja` vu all over again.

We are all here together again. It is almost 2 years to the day

when Chairman Greenspan testified before us, and again, the

President has proposed tax cuts that have a profound fiscal impact.

Again, we are trying to sort through it all to find the best policy.

But one thing is different today. Instead of surpluses, we have

ever-widening deficits as far as the eye can see. And I believe we

need strong and independent voices to speak out against this everincreasing fiscal imprudence.

I disagree with my good friend from Kentucky. We need your

voice. It is our hope that you will be one of those voices that speaks

out against this fiscal imprudence because there is no stronger, no

more respected, and no more needed voice than yours today.

Our hope is that we do not end up in a true fiscal morass down

the road. I very much look forward to the Chairman’s comments.

Chairman SHELBY. Senator Sununu.

COMMENTS OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman.

Welcome, Chairman Greenspan. I appreciate your taking the

time. I know these hearings are extremely time-consuming and you

are faced with Members of Congress, on the House side and on the

7

Senate side, that would like to explain to you exactly how we would

act if we had your job. So, I appreciate your patience.

This is an important time internationally and domestically. I

would be very interested in hearing your thoughts today about how

the long-term prospects of establishing greater stability overseas,

such as in Iraq and North Korea, can promote a better investment

climate and can help accelerate whatever benefits—either from tax

policy or fiscal policy—here in the United States, I look forward to

your testimony.

Thank you.

Chairman SHELBY. Senator Bayh.

COMMENTS OF SENATOR EVAN BAYH

Senator BAYH. Thank you, Chairman Shelby.

Chairman Greenspan, thank you for being with us today. We are

all here to hear from you and so I am going to save my comments

for the question period.

Chairman SHELBY. Senator Dole.

COMMENTS OF SENATOR ELIZABETH DOLE

Senator DOLE. Thank you, Mr. Chairman.

Mr. Greenspan, I certainly appreciate very much the opportunity

as a new Member of the Committee to hear your report this morning. And in the interest of time, I am going to submit my formal

statement for the record.

Chairman SHELBY. Without objection, it will be made part of the

record.

Senator Miller.

COMMENTS OF SENATOR ZELL MILLER

Senator MILLER. Thank you, Chairman Shelby, for holding this

hearing.

I have no opening statement, but we are glad to have you with

us again, Chairman Greenspan.

Chairman SHELBY. Senator Crapo.

COMMENTS OF SENATOR MIKE CRAPO

Senator CRAPO. Thank you, Mr. Chairman. I will be brief as well.

Chairman Greenspan, I appreciate the opportunity to meet with

you again and look forward to your testimony.

Obviously, from some of the comments that have already been

made, it is very clear that your opinion on economic matters carries

a significant amount of weight. I, along with the others that are

here, are going to be looking very closely at your evaluation of what

is needed in our economy, not only in terms of some of the economic policy decisions that we will be making here in Congress

with regard to the President’s proposal, but also with regard to

some of the issues that have been around previously.

For example, the derivatives issue still may arise. And I expect

that during the question and answer period, to have an opportunity

to discuss that with you, to see if your opinion has changed at all

on how we should approach those types of issues.

8

But, again, as some of my collegues have indicated, we are here

to listen to you. And I look forward to the opportunity that we have

to visit with you today.

Thank you.

Chairman SHELBY. Senator Carper.

STATEMENT OF SENATOR THOMAS R. CARPER

Senator CARPER. Thanks, Mr. Chairman.

Chairman Greenspan, welcome. We are delighted to have you

with us today.

One of my colleagues said earlier today that the President should

not try to fix monetary policy any more than the Chairman of the

Federal Reserve should try to fix fiscal policy.

I was just thinking—how many Presidents have we seen in my

lifetime who tried to fix monetary policy? I am not going to ask you

to address that question. But I think most of us here know that

there has been some precedent for that.

I share with you a conversation we had with some Democratic

and Republican centrist Senators not so long ago, conversations I

had with some business leaders back in my own State of Delaware,

where we talked about what we needed to do to get the economy

moving.

They talked a whole lot about uncertainty. They spoke of the uncertainty that we have faced with investor confidence, lack of investor confidence over the last year and hopefully, the steps that we

have taken here today in moving forward the nomination of Bill

Donaldson to chair the Securities and Exchange Commission will

help to alleviate some of that uncertainty.

As time goes by, the implementation of the Sarbanes-Oxley legislation will hopefully help to boost investor confidence as well.

We have uncertainty because of the fear of terrorist attacks.

What are we in—orange alert these days, and a whole lot of uncertainty that continues to swirl around that.

We have faced the uncertainties of the elections. We have survived the elections. We now know who is in the majority and who

is not.

We still face the uncertainty of a potential war with Iraq, the effect that that war will have on energy prices, on the availability

of oil, the prospect of an altercation with North Korea as we deal

with them and their problems.

We have all kinds of uncertainty that flow out of class action

lawsuits where little local courts in places like East St. Louis, Illinois and places in Alabama and Texas are making national class

action law for our country.

We see uncertainty facing companies with little exposure to asbestos that are actually taking them under and putting them into

bankruptcy.

We see uncertainty with spiraling health care costs. And we see

the uncertainty of a trade deficit, where we have gotten better at

exporting jobs. Not just manufacturing jobs, but jobs that are highpaying jobs—software jobs, technology jobs that are going abroad

faster than we would like to think.

The last thing that I wanted to say is I had an interesting meeting with Dan Crippen, our recently departed CBO Chairman. He

9

put in context the Administration’s tax cut proposal and talked

about its effect on the economy.

He looked ahead for the next 10 years and said, GDP for the next

10 years will be about $120, $130, maybe $140 trillion. He also said

the size of this tax cut proposal that we are looking at is about

$650 billion. An economy of $140 trillion for the next 10 years,

about a $650 billion tax cut.

And what he said then really helped me put it in context. He

said it is a 65-cent change to a $140 economy.

Sometimes we delude ourselves, I think, by presuming that a tax

cut or a spending policy is going to somehow move the economy,

when actually what we do is relatively small compared to the size

of the economy itself.

I would just say to my colleagues, and certainly to you, and to

the Administration, that we need to deal with uncertainty to get

the economy moving.

You have done a great job on monetary policy. You have done a

terrific job and you are to be commended for that.

Thank you.

Chairman SHELBY. Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman.

First, I want to commend our new Chairman for producing an

immediate quorum this morning to report Mr. Donaldson out of the

Committee, and I would like to join that favorable vote. In fact, Mr.

Chairman, with your indulgence and that of my colleagues, I would

like to make just a short statement about Mr. Donaldson.

In my view, he brings considerable relevant experience to this

new assignment as Chairman of the SEC. He founded and managed a major investment company, Donaldson, Lufkin & Jenrette.

He served as Chairman and CEO of the New York Stock Exchange.

He was Chairman and President and CEO of a multibillion dollar

public company. And he was the first Dean and Professor at the

Yale School of Management.

He will face a daunting task as the new Chairman of the SEC.

He must join with his fellow Commissioners in appointing the

Chairman of the Public Company Accounting Oversight Board. He

must address the challenge of restoring confidence to the capital

markets. And I very much hope that he would move immediately

to implement pay parity at the SEC.

I am pleased in his appearance before the Committee of recognizing the importance and immediate challenge of implementing

the accounting responsibility and investor protection legislation we

passed here in the Congress last year.

At his confirmation hearing, he testified that he will vigorously

enforce Sarbanes-Oxley and the rules and regulations already put

forth by the SEC.

He went on to say: ‘‘I will demand accountability from all responsible parties. I will aggressively enforce civil penalties and work cooperatively with the State and Federal law enforcement agencies

and the President’s Corporate Fraud Task Force to bring those who

break the law to justice.’’

10

He went on to pledge to call on corporate America and Wall

Street to restore the principles of honesty and integrity to their

proper place. He indicated a strong concern for the welfare of the

employees of the SEC. He pledged to address issues of morale and

union relations at that Agency.

I am hopeful that Mr. Donaldson will effectively manage the SEC

and effectively enforce the Federal securities laws and that he will

bring about a new era of respect for the Agency and confidence in

the U.S. securities markets.

And I know, Mr. Chairman, you have indicated an intention on

the part of this Committee to follow closely with oversight hearings

the activities at the SEC.

Chairman SHELBY. Absolutely.

Senator SARBANES. I am very pleased to join with my colleagues

in welcoming Chairman Greenspan before our Committee this

morning to testify on the Federal Reserve’s Semi-Annual Monetary

Policy Report to the Congress.

The Federal Reserve was created with an act of Congress. We

have the oversight responsibility over the activities of the Federal

Reserve.

We have tried to formalize those with these semi-annual reports

to the Congress, which I think are extremely important. I am

pleased that Chairman Greenspan is back before us carrying out

this responsibility.

I want to make brief reference to the statement that was signed

by the economists, including 10 Nobel Prize Winners, that was just

released yesterday. They have pointed out the slowdown in the economic growth, the loss of private-sector jobs, the over-capacity, corporate scandals, and uncertainty weigh down the economy.

They view with considerable concern—one might say almost

alarm—the tax cut plan proposed by the President, as a permanent

change in the tax structure rather than directed toward the shortterm problem of creating jobs and growth, and note that it would

worsen the long-term budget outlook, adding to the Nation’s projected chronic deficits.

Some of my colleagues have pointed out, when President Bush

came into office in January 2001, that the Federal Government was

projecting a 10-year surplus of $5.6 trillion. In fact, Chairman

Greenspan came before the Senate at that time supporting a tax

cut proposed by President Bush on the grounds that the Government was paying off its debt too fast. I remember that hearing as

though it were yesterday. Chairman Greenspan argued that a tax

cut was needed, to ‘‘smooth the glide path,’’ so that the Government

debt would not be paid off too quickly and put the Government in

the position of acquiring private assets.

Well, that was then and this is now.

If the President’s program were enacted into law, the program

currently being proposed, the budget projections for the same 10-

year period would be a $2.1 trillion deficit. In other words, we have

gone from projecting a $5.6 trillion surplus to where we would now

project a $2.1 billion. Trillion. Excuse me—$2.1 trillion deficit. That

is obviously a shift of $7.7 trillion. That projected figure does not

include the cost of a possible war with Iraq—probably one should

strike the word possible. It also does not include tax changes such

11

as the reform of the alternative minimum tax and the extension of

tax provisions currently scheduled to sunset, which almost certainly will be extended. We have done that continuously.

By any measure, we are in the process of transforming the fiscal

position of the United States from one of fiscal surplus to one of

large fiscal deficits. Given the scale of the deficits that would be

created by the President’s plan, fundamental questions are raised

about the impact of deficits on interest rates, investment, growth,

and jobs in our economy.

Witnesses for the Administration are downplaying the impact of

budget deficits. I might note that many of these witnesses not very

long ago were in here testifying in favor of the balanced budget

amendment to the Constitution of the United States, to require

that the Federal Government have a balanced annual budget.

In the face of the uncertain demands on public resources imposed

by the war on terrorism, by homeland defense, by our difficulties

with North Korea, and the march toward war with Iraq, I think

the President’s fiscal proposals are reckless and irresponsible.

It would deny us the public resources we need to meet current

and future challenges. It would put upward pressure on long-term

interest rates, which would reduce economic growth and impose

greater hardship on middle and working class Americans.

Mr. Chairman, I look forward to reviewing these and other issues

with Chairman Greenspan this morning.

Thank you very much.

Chairman SHELBY. Senator Johnson.

STATEMENT OF SENATOR TIM JOHNSON

Senator JOHNSON. Thank you, Chairman Shelby, and Ranking

Member Sarbanes. And thank you for convening today’s hearing to

examine the monetary policy of the United States. We are privileged to have before us Chairman Alan Greenspan, and I welcome

him here today to the Senate Banking Committee.

Today, as we gather to hear about the state of America’s economy, we face a grim picture. It is sobering to note, as Ranking

Member Sarbanes has just observed, that just 2 years ago, in this

very room, Chairman Greenspan cautioned this Committee about

the dangers of paying down the national debt too quickly. Now just

a short time later, we face a $304 billion deficit this year alone,

and a deficit of more than $2 trillion projected over the next 10

years. That is without counting the costs of war, the AMT fix, or

homeland security, the war and homeland security both being particularly unknown and contingent in terms of the nature of the expense that that will entail, other than the obvious observation that

it will be extraordinarily costly.

I speak in a somewhat unique circumstance among my colleagues in that in 2001, I voted to support President Bush’s $1.3

trillion tax cut. And while I worked to moderate the cost of that

tax cut in its initial proposal, and while I worked to redirect more

of those resources toward middle class and working families, I

agreed with Chairman Greenspan, who has often warned that Government should not accumulate taxpayer dollars. At the time that

I voted for that tax relief, this country faced historically high surpluses projected at $5.6 trillion for fiscal years 2002 through 2011,

12

and I committed myself to assisting to return surplus funds to the

taxpayer at that time. I did so, however, on the condition that

President Bush himself reiterated during his most recent State of

the Union address when he said: ‘‘We will not pass along our problems to other Congresses, other Presidents, and other generations.’’

It is difficult to believe that our circumstances have changed so

dramatically since President Bush took office 2 short years ago. It

is even more difficult to believe that President Bush appears determined to do exactly the opposite of what he pledged not to do. That

is, pass along our actions to the next generation.

And frankly, I am appalled at the President’s recklessness in proposing a massive tax cut targeted for the rich, while so many of our

Nation’s basic needs go unmet and while the prospect of enormously deep budget deficits loom before us. I simply cannot understand the impulse to plunge our Nation into even more staggering

deficits at this time.

Now, I believe that any stimulus plan has to meet three simple

conditions: One, it should give tax relief to working families who

need it and who will spend it. Two, it should give tax relief now,

while the economy is weak. And three, it should not saddle our

children and grandchildren with additional debt.

In 2001, we were faced with record surpluses. Times have

changed radically. And as I look, and as my constituents look back

at what has gone on over the last several years, we have gone from

a time when, frankly, the Democrats were in control in the White

House and the Congress and the economy was deep in red ink. And

the advice was to balance the budget, and that should come ahead

of education and health care and other domestic needs. And that

was done.

Then, we reached a time when Democrats again were in control

in Congress, at the White House, and times were good, and we had

budget surpluses. Again, the recommendation was tax cuts should

come ahead of education, health care, and other domestic needs.

Now, we find ourselves with our Republican friends at the White

House and in Congress, and the circumstances again deep in red

ink and the advice yet again is tax cuts ahead of education, health

care and other domestic needs.

My constituents are wondering whether this is economic advice

we are receiving or whether it is simply political ideology, whether

this has less to do with the economy than it does with bankrupting

the Federal Government so that we do not find ourselves in a position where we can invest in our schools, in our families, in our

kids, in the infrastructure that we need to have, in the health care

needs of our people.

I have to tell you that the observations that I hear from my constituents are grim, indeed, about where this country is going and

what the prospects are going to be in the future years if we continue to follow down this road of fiscal irresponsibility.

I appreciate the opportunity to listen to your words of advice, Mr.

Greenspan, here today. I share with you the observations of so

many of my constituents and the great fear and concern they have.

I look forward to a very constructive hearing today. Thank you,

Mr. Chairman.

Chairman SHELBY. Senator Corzine.

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COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman.

First of all, I am pleased that we are having this hearing and

I welcome Chairman Greenspan. It is ironically disturbing to me

that I am bouncing back and forth between the Foreign Relations

Committee and here today. The two issues on the table are very

much interconnected. We have a tragedy of the war on terrorism

ongoing, a real element of concern to the American public. We have

risks of war, and we are having a hearing on the costs of reconstruction of Iraq in a post-conflict period. And I am hearing from

Under Secretary Grossman in that hearing that it will take a long

and sustained commitment.

Times have changed. The world has changed, whether it is with

regard to national security issues. And certainly, anyone’s reading

of the budget and economic conditions, which we have heard my

colleagues speak of.

I look forward to hearing how the Federal Reserve and one of

those people most respected in the world believes we should

change, given the changing circumstances and environment we face

with regard to the economy.

These are truly times of challenge for our Nation. And it is very

hard for one to understand how we can, in the first time in our history at least that I know of, that we have chosen to have tax cuts

in the midst of such great national challenge.

I will be anxious to hear what the Chairman has to say about

these kinds of issues.

Thank you.

Chairman SHELBY. Mr. Chairman, welcome again to the Committee. Your written statement will be made a part of the record

in its entirety. You may proceed as you wish.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN

BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Chairman GREENSPAN. My written statement, as you know, Mr.

Chairman, is rather extended and I do not intend to speak more

than 10 to 12 minutes, which would be a significant excerpt out of

that long testimony.

Mr. Chairman and Members of the Committee, when I testified

before this Committee last July, I noted that, while the growth of

economic activity over the first half of the year had been spurred

importantly by a swing from rapid inventory drawdown to modest

inventory accumulation, that source of impetus would surely wind

down in subsequent quarters, as it did. We at the Federal Reserve

recognized that a strengthening of final sales was an essential element of putting the expansion on a firm and sustainable track. To

support such a strengthening, monetary policy was set to continue

its accommodative stance.

In the event, final sales continued to grow only modestly, and

business outlays remained soft. Concerns about corporate governance, which intensified for a time, were compounded over the late

summer and into the fall by growing geopolitical tensions. Equity

prices weakened further, the expected volatility of equity prices

rose to unusually high levels, spreads on corporate debt and credit

default swaps deteriorated, and liquidity in corporate debt markets

14

declined. The economic data and the anecdotal information suggested that firms were tightly limiting hiring and capital spending

and keeping an unusually short leash on inventories.

By early November, conditions in financial markets had firmed

somewhat. But on November 6, with economic performance remaining subpar, the Federal Open Market Committee chose to ease the

stance of monetary policy, reducing the Federal funds rate 50 basis

points, to 11⁄4 percent. We viewed that action as an insurance

against the possibility that the still widespread weakness would become entrenched.

In the weeks that followed, financial market conditions continued

to improve, but only haltingly. Mounting concerns about geopolitical risks and energy supplies were mirrored by the worrisome

surge in oil prices, continued skittishness in financial markets, and

substantial uncertainty among businesses about the outlook.

Partly as a result, growth of economic activity slowed markedly

late in the summer and in the fourth quarter. Much of that deceleration reflected a falloff in the production of motor vehicles from

the near-record level that had been reached in the third quarter

when low financing rates and other incentive programs sparked a

jump in sales. The slowing in aggregate output also reflected aggressive attempts by businesses more generally to ensure that inventories remained under control. Thus far, those efforts have

proven successful in that business inventories, with only a few exceptions, have stayed lean.

Apart from these quarterly fluctuations, the economy has largely

extended the broad patterns of performance that were evident at

the time of my July testimony. Most notably, output has continued

to expand, but only modestly. As previously, overall growth has simultaneously been supported by relatively strong spending by

households and weighed down by weak expenditures by businesses.

Importantly, the favorable underlying trends in productivity have

continued. One consequence of the combination of sluggish output

growth and rapid productivity gains has been that the labor market has remained quite soft.

Another consequence of the strong performance of productivity

has been its support of household incomes despite the softness of

labor markets. Those gains in income, combined with the very low

interest rates and reduced taxes, have permitted relatively robust

advances in residential construction and household expenditures.

The increases in consumer outlays have been financed partly by

the large extraction of built-up equity in homes.

While household spending has been reasonably vigorous, we have

yet to see convincing signs of a rebound in business outlays. The

emergence of a sustained and broad-based pick-up in capital spending will almost surely require the resumption of substantial gains

in corporate profits.

Of course, the path of capital investment will also depend on the

resolution of the uncertainties surrounding the business outlook.

The intensification of geopolitical risks makes discerning the

economic path ahead especially difficult. If these uncertainties diminish considerably in the near term, we should be able to tell far

better whether we are dealing with a business sector and an economy poised to grow more rapidly—our more probable expectation—

15

or one that is still laboring under persisting strains and imbalances

that have been misidentified as transitory.

If instead, contrary to our expectations, we find that, despite the

removal of the Iraq-related uncertainties, constraints to expansion

remain, various initiatives for stimulus will doubtless move higher

on the policy agenda. But as part of that process, the experience

of recent years may be instructive. As I have testified before this

Committee in the past, the most significant lesson to be learned

from recent American economic history is arguably the importance

of structural flexibility and the resilience to economic shocks that

it imparts.

I do not claim to be able to judge the relative importance of conventional stimulus and increased economic flexibility to our ability

to weather the shocks of the past few years. But the improved flexibility of our economy, no doubt, has played a key role. That increased flexibility has been in part the result of the ongoing success

in liberalizing global trade, a quarter-century of bipartisan deregulation that has significantly reduced rigidities in our markets for

energy, transportation, communication, and financial services, and,

of course, the dramatic gains in information technology that have

markedly enhanced the ability of businesses to address festering

economic imbalances before they inflict significant damage. This

improved ability has been facilitated further by the increasing willingness of our workers to embrace innovation more generally.

It is reasonable to surmise that but, not only have such measures

contributed significantly to the long-term growth potential of the

economy this past decade, but they have also enhanced its shortterm resistance to recession. That said, we have too little history

to measure the extent to which increasing flexibility has boosted

the economy’s potential and helped damp cyclical fluctuations in

activity.

Even so, the benefits appear sufficiently large that we should be

placing special emphasis on searching for policies that will engender still greater economic flexibility and dismantling policies that

contribute to unnecessary rigidity. The more flexible an economy,

the greater its ability to self-correct in response to inevitable, often

unanticipated, disturbances, thus reducing the size and the consequences of cyclical imbalances. Enhanced flexibility has the advantage of adjustments being automatic and not having to rest on

the initiatives of policymakers, which often come too late or are

based on highly uncertain forecasts.

Policies intended to improve the flexibility of the economy seem

to fall outside the sphere of traditional monetary and fiscal policy.

But decisions on the structure of the tax system and spending programs surely influence flexibility and thus can have major consequences for both the cyclical performance and long-run growth

potential of our economy.

As we approach the next decade, we need to focus attention on

this necessity to make difficult choices from among programs that,

on a stand-alone basis, appear very attractive.

Because the baby boomers have not yet started to retire in force,

and accordingly, the ratio of retirees to workers is still relatively

low, we are in the midst of a demographic lull. But short of an outsized acceleration of productivity to well beyond the average pace

16

of the past 7 years or a major expansion of immigration, the aging

of the population now in train will end this state of relative budget

tranquility in about a decade’s time. It would be wise to address

this significant pending adjustment and the associated potential for

the emergence of large and possibly unsustainable deficits sooner

rather than later. As the President’s just-released budget put it:

‘‘The longer the delay in enacting reforms, the greater the danger,

and the more drastic the remedies will have to be.’’

Reestablishing budget balance will require discipline in both revenue and spending actions, but restraint on spending may prove

the more difficult. Tax cuts are limited by the need for the Federal

Government to fund a basic level of services—for example, national

defense. No such binding limits constrain spending. If spending

growth were to outpace nominal GDP, maintaining budget balance

would necessitate progressively higher tax rates that would eventually inhibit the growth in the revenue base on which those rates

are imposed. Deficits, possibly ever widening, would be the inevitable outcome.

Faster economic growth, doubtless, would make the deficits far

easier to contain. But faster economic growth alone is not likely to

be the full solution to currently projected long-term deficits. To be

sure, underlying productivity has accelerated considerably in recent

years. Nevertheless, to assume that productivity can continue to

accelerate to rates well beyond the current underlying pace would

be a stretch, even for our very dynamic economy. So short of a

major increase in immigration, economic growth cannot be safely

counted upon to eliminate deficits and the difficult choices that will

be required to restore fiscal discipline.

By the same token, in setting budget priorities and policies, attention must be paid to the attendant consequences for the real

economy. Achieving budget balance, for example, through actions

that hinder economic growth is scarcely a measure of success. We

need to develop policies that increase the real resources that will

be available to meet our longer-term needs. The greater the resources available—that is, the greater the output of goods and services produced by our economy—the easier will be providing real

benefits to retirees in coming decades without unduly restraining

the consumption of workers.

These are challenging times for all policymakers. Considerable

uncertainties surround the economic outlook, especially in the period immediately ahead. But the economy has shown remarkable

resilience in the face of a succession of substantial blows. Critical

to our Nation’s performance over the past few years has been the

flexibility exhibited by our market-driven economy and its ability

to generate substantial increases in productivity. Going forward,

these same characteristics, in concert with sound economic policies,

should help to foster a return to vigorous growth of the U.S. economy to the benefit of all our citizens.

Thank you very much, Mr. Chairman. I look forward to your

questions.

Chairman SHELBY. Thank you.

Chairman Greenspan, you are well known for your comments

several years ago concerning the irrational exuberance of financial

markets.

17

Over the past year, we have seen a significant decline in financial markets, due in part to not only an economic slowdown, but

also because of a decline in investor confidence. In fact, the

NASDAQ is below the level it was when you made your comments

several years back. In your opinion, have we now moved from irrational exuberance to excessive anxiety?

Chairman GREENSPAN. Well, it is always difficult to make those

judgments, Mr. Chairman, but the fact that there is some anxiety

in the markets I think is very evident.

Indeed, the general context of my prepared remarks is that,

pending full confirmation of the impact of what we call geopolitical

risks, we do not know what the underlying strength of this economy is. My suspicion, and I emphasize it is very difficult to know

for sure, is that that geopolitical risk is hanging very heavily on

economic decisionmaking and hence, economic growth. And its

elimination should, in my judgment, make a very considerable

difference.

Chairman SHELBY. Thank you. Do you believe that sufficient actions have been taken to restore investor confidence or that we

need to do more to restore market credibility?

Chairman GREENSPAN. I think that the statute which was essentially formulated by Senator Sarbanes and Congressman Oxley has

gone a very significant way in eliminating a considerable amount

of the incredible corporate malfeasance which we saw over the last

year or so; or at least was exposed over the last year or so.

I do think that the issue of the statute is not wholly related to

the short-term. It is mainly, in my judgment, related to the longer

term when the next generation, having accrued irrational exuberance, is apt to go down very similar paths that we have seen

the current generation go down.

I do think that, as best I can judge, a considerable amount of the

malfeasance which I think is so rightly addressed by the Senator’s

and the Congressman’s statute, is not a major problem for the immediate future. I do not deny that we are likely to find additional

examples of rather atrocious accounting, atrocious behavior, and I

find that more likely than not.

But I would be very surprised if it were initiated beyond mid2002 because the decline in the market and the response of the

Congress and the political system to some of the actions I think

chastised the business community in a way which had the equivalent of almost eliminating a high fever which seemed to have

gripped people who were otherwise very ethical, very responsive to

their shareholders, and responsive to making their companies as

best as they could.

Virtually all of them, listening to their commentary, have seemingly come out of this fever-ridden view toward how to harvest

those huge capital gains and restored, in many respects, some of

the actions which they did in a more sensible way in years past.

Chairman SHELBY. Mr. Chairman, homeowners have benefited

greatly in recent years from continued low interest rates and rising

home values. The outstanding value of revolving home equity loans

at commercial banks rose from $155.5 billion in December 2001, to

$212.3 billion in December 2002, just 1 year. Homeowners use this

money to make other purchases or to pay down some debt. Should

18

we have any concerns about consumers being over-extended

through these home equity loans? Would there be an adverse impact if home prices no longer appreciate or even decline?

Chairman GREENSPAN. Senator, we have looked at that in some

considerable detail, and the result of our analysis is the following:

If you take overall mortgage debt, which would include home equity debt and you compare it to the level of disposable income of

homeowners only, the level of the debt is rising relative to income,

but not significantly so. However, with the very marked decline in

interest rates, the debt service cost as a percent of disposable income of owner-occupied households, is actually average or, if anything, somewhat less than average.

Now, I hasten to add that a goodly part of this is the rather low

interest rates that exist in the mortgage market. But unless interest rates come back very sharply, which would presumably occur

in the context of rapid economic recovery or an acceleration of inflation, which I do not anticipate, the balance of debt in the mortgage market generally, even though very large, is not, in our judgment, a cause of concern.

We would be concerned if the price of homes in general across

the country moved down rather considerably. And there was a good

deal of concern, as you know, about this housing bubble. But our

evaluation of the data and the outlook suggests that, while obviously there are potential problems, they are not serious ones that

need to be addressed in any material way as far as we can judge.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you very much, Mr. Chairman.

Chairman Greenspan, The Washington Post this morning has a

story headlined: ‘‘Greenspan Likely To Back Dividend Plan,’’ referring to the President’s proposal with respect to the taxation of corporate dividends. It points out later that the tax changes that the

President is seeking would cost well over a trillion dollars in the

next 10 years. Do you back the dividend plan?

Chairman GREENSPAN. Let me make two points with respect to

this, Senator.

The first thing is, I have always supported the elimination of the

double taxation of dividends because I think it is a major factor restraining flexibility in our economy. And as I pointed out in my

prepared remarks, moving in the direction of improving flexibility

I think has very large, long-term payoffs.

However, I also commented in my prepared remarks and, indeed,

testified before the House Budget Committee, that PAYGO rules,

which expired in September in the House, and will expire here, are

very important for the budgetary process.

So, I do support the elimination of the double taxation of dividends. I would prefer that it be done at the corporate level. But I

think the way it is constructed in the President’s program makes

a good deal of sense over the long run as well.

But in my judgement, any such initiative should be in the context of PAYGO rules, which means that the deficit must be maintained at minimal levels.

Senator SARBANES. Just last July, you testified before this Committee, and I am now going to read you a quote and follow up with

a couple of questions on the double taxation of dividends. You said:

19

The fundamental aspect of this question really gets down to the double taxation

of dividends and the issue of the integration of the corporate tax with the individual

tax. And I think a lot of economists will tell you that it is an extraordinarily useful

and efficient way, if you can do it, to put all of the tax burden on shareholders and

not have double taxation of dividends through taxing the corporation and then taxing the dividends again.

My own impression is that we should have a very large expansion of subchapter S corporations which effectively would enable

dividends to be paid out and effectively taxed only once.

I do not expect that to happen at this particular stage and there

are very good reasons why problems of revenue loss are creating

a concern. There are issues of equity. But if you are asking as an

economist and looking strictly at the question of the optimum allocation of capital in the system, eliminating double taxation of dividends is a very valuable thing to do.

Now it seems to me that the key question is not whether you

support ending double taxation of dividends as a matter of abstract

tax policy. But whether you think it should be financed by deficit

spending or whether it should be paid for.

That in turn raises the fundamental issue of whether deficits

matter and whether deficits affect long-term interest rates, savings,

investment, and growth.

You are on the record on that issue as well, but I would like you

to respond to two questions. And in the course of asking them, I

note that the economists who issued the statement opposing the

Bush tax cuts, the 10 Nobel Prize winners and many, many others,

said in the course of that statement—the permanent dividend tax

cut in particular is not credible as a short-term stimulus.

As tax reform, the dividend tax cut is misdirected in that it targets individuals rather than corporations, is overly complex, and

could be, but is not, part of a revenue-neutral tax reform effort.

Now given that your position has been that you want to address

the double taxation, do you think it should be financed out of deficits in order to correct that problem?

Chairman GREENSPAN. Well, if I support, and I argued very

strenuously at the House Budget Committee last September, and

indeed, repeated part of that testimony in my prepared remarks,

that the process that you go through in constructing the budget has

been very effectively enhanced by PAYGO rules and discretionary

caps, then the way I would answer the question is, yes, I do think

that eliminating the double taxation of dividends in any of the various forms, including subchapter S or taking the tax deduction at

the individual level or at the corporate level—and as I said, from

a commerce point of view, it is the latter that is the best. But they

are all I think quite important and useful.

The reason is that they improve the flexibility of the economy.

And the one thing I have sensed as the last 2 or 3 years have gone

on is how really important that apparently is.

Having said that, there is no question that as deficits go up, contrary to what some have said, it does affect long-term interest

rates. It has a negative impact on the economy, unless attended.

As I have indicated in my prepared remarks and, indeed, in my

oral remarks, I think that there are major problems which must be

addressed, which means that we just cannot keep adding programs

20

of one form or another to a limited expansion capability in the

economy.

I would argue that we should be doing both, namely trying to

move toward increased flexibility, but being very careful not to

allow deficits to get out of hand, especially when we are going to

be running into a significant problem starting 2010, 2012, and beyond with a very significant acceleration in beneficiaries for both

Social Security and Medicare.

Senator SARBANES. Mr. Chairman, let me just close.

Two years ago almost to the day, you said before this Committee,

and I want to see whether you still adhere to this statement, and

I am now quoting you: ‘‘In recognition of the uncertainties in the

economic and budget outlook, it is important that any long-term

tax plan or spending initiative . . .’’ let me just emphasize that,

long-term tax plan or spending initiative ‘‘. . . for that matter, be

phased in. Conceivably, it could include provisions that in some

way would limit surplus-reducing actions if specified targets for the

budget surplus and Federal debt were not satisfied.’’

Now this is when we are dealing with a surplus question. We are

dealing with a deficit question. Even the Administration itself is

projecting deficits of $300 billion over the next 2 fiscal years.

Then to go on with your quote: ‘‘Now, what I am obviously referring to is the desirability of eliminating the Federal debt, which is

still frankly, my first priority because I think that it has had an

extraordinarily important impact on the economy, on the financial

markets, on long-term interest rates, and on economic growth.’’

Do you still hold to that statement?

Chairman GREENSPAN. I do, Senator.

Senator SARBANES. All right. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Allard.

Senator ALLARD. Thank you, Mr. Chairman.

Around September 2002, many of the opponents of the temporary

tax cut of 2 years ago, admitted that they felt like it kept the economy from bottoming out at a potentially lower number. In other

words, the tax cut did help the economy some. That was even noted

in an editorial in The Washington Post in September.

What conditions have changed now that would show that we

should not advance those tax cuts or make them permanent in

order to further help the economy?

Chairman GREENSPAN. Senator, as I implied in my remarks, I

am one of the few people who still are not as yet convinced that

stimulus is a desirable policy at this particular point.

It depends very much on how one reads what is effectively going

on under the whole structure of geopolitical and other risk. And

unless and until we can make a judgment as to whether, in fact,

there is underlying deterioration going on, and my own judgment

is I suspect not, then stimulus is actually premature.

I support the President’s proposal on eliminating the double taxation, not as a short-term stimulus measure, but as long-term, good

corporate tax policy and something which would add to the longterm flexibility and potential growth of the economy. But unless it

turns out that there really is a very weak underlying structure

even beneath this degree of uncertainty, which I will grant you will

21

then change our view with respect to the desirability of stimulus

beyond what has already been put in place by the Federal Reserve

in its fairly significant decline in short-term interest rates, we have

to be in a position to be able to state that we see that as a very

significant problem and one which must be addressed in a manner

which would then clearly be necessary.

I suspect it is not. But I cannot say with any degree of assurance

that I feel comfortable with that conclusion.

Senator ALLARD. Mr. Chairman, we are possibly facing the need

for Congress to increase the debt limit. The debt limit reflects not

only public debt—it is a total debt limit. It reflects obligations, as

you know, to the general fund, both from the trusts, as well as the

public debt.

There is some discussion as to whether, in dealing with the debt

limit, we should just concern ourselves with public debt or whether

we should concern ourselves just with the total debt limit figure.

In other words, instead of putting that limit on total debt, maybe

modify it so that it is just on the public debt. I would like to hear

your comments on that, sir.

Chairman GREENSPAN. Well, I have testified on this previously,

Senator, and I will just repeat what I said then, which is, if you

are going to do this, then putting it on debt to the public, which

is now a number which excludes debt held by investment accounts

of the Federal Government, obviously, that is the economic variable

you should be adjusting it to.

But having said that, you have already, or will have already, constructed a debt limit by the various votes that you have had with

respect to authorizing receipts and outlays. And either that debt

limit is redundant, meaning that it is the same number that is implicit in the difference between receipts and expenditures, coupled

with the debt at the beginning of the period, or it is inconsistent

and you are creating contradictory law.

So, I conclude, as I did in my prepared remarks, that the debt

ceiling is not a useful fiscal tool and, indeed, has never in my judgment been successful in doing what it is supposed to have been

doing—namely, constrain spending. I would think it would be wise

to eliminate it.

Senator ALLARD. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Dodd.

Senator DODD. Thank you, Mr. Chairman. Let me pick up, if I

can, a bit on what Senator Sarbanes was raising.

In your testimony here this morning, you said:

As I testified before this Committee in the past, the most significant lesson to be

learned from recent American economic history is arguably the importance of structural flexibility and the resilience to economic shocks . . .

I want to raise the question of the permanency of the tax cuts

that are being sought, the ones that were adopted in the spring of

2001. Obviously, major events have occurred since then that have

caused us to have to examine our fiscal policies for all the obvious

reasons.

I note that you have taken the position, before the Joint Economic Committee, that the tax cuts are not stimulative. You do not

believe them to have any stimulative effect.

22

But you also argue that because there is a presumption that

these tax cuts are already permanent in the economy, that to not

make them permanent would be unwise. And I want to raise that

particular issue.

These are tax cuts that go out 10 years. How do you square

agreeing to a permanency of a 10-year tax cut proposal with structural flexibility at a time when we have so many demands that are

going to be made on us for all the obvious reasons, both including

domestic pressures, as well as anywhere from, according to some

economists, $100 billion to in excess of $1 trillion, the cost of the

war in Iraq and the after-effects?

Chairman GREENSPAN. Well, Senator, my response to that question at an earlier time was the endeavor to try to recognize that

it is just not credible to have a significant tax cut which sunsets

10 years out. Markets do not believe it. It makes no fiscal sense

and you are far better off making it permanent, but putting everything under PAYGO in a manner which addresses the broad issues

of the deficit.

The Congress has to make judgments because it is the only vehicle which ultimately has the authority to make choices among some

very difficult programs. That is, I do not know a single program

which has been authorized by the Congress over the years which

was not perceived to be beneficial, either as a spending program or

a tax cut.

The trouble is that when you add them all up, they come to a

total larger than the fiscal capacity of the country as measured by

our gross domestic product, which means choices must be among

things which on a stand-alone basis are very good, desirable, and

meet any cost-benefit analysis you can think of.

So what we are dealing with is the issue of how to make choices.

And the most difficult problem that exists with respect to long-term

budget issues is getting them right.

But as I have said in previous testimony—indeed, I said it in the

current testimony—we almost surely will never get it right. Therefore, we have to consider issues of triggers and sunset legislation

in order to make midcourse corrections, not if, but when policies go

off the long-term, expected track.

And because there has been a very substantial change in budgetary policy over the last 20, 30, 40 years, in the sense that we

have moved from 1-year budgets and essentially two-thirds discretionary spending to exactly the reverse, and indeed, we have gone

from, as I said, the 1-year, to then 5-year, mandated under the

1979 Act, and by the mid-1990’s, to 10-year horizons, because our

programs are projecting out that far, even though we know we cannot estimate them with any great accuracy, we need new devices

for long-term fiscal policy.

In my judgment, the most significant ones that we need are the

ones which we are allowing to basically expire, the PAYGO and

discretionary caps, and importantly, over the longer-term, triggers,

and to the extent that it is important, sunset legislation. Because

the existing tools that we now employ for budgetary policy are not

significantly different from what they were 30, 40 years ago. And

these are very different budget processes that we are involved in.

23

Senator DODD. Just a quick follow-up, then. I am somewhat confused here.

The permanency of these tax cuts over the next 10 years, I do

not disagree. In fact, I have supported over the years pay-as-yougo proposals and so forth. I understand the value of that.

We are looking, for instance, at budget cuts that are occurring

in a number of areas where people anticipated that there would be

a Federal commitment in certain areas and seeing the pressures

occur at the State and local level as a result of our changing direction here. Just most recently in the COPS program, for instance,

in which local departments and States counted on over the years.

All of a sudden, that program is going to be eliminated, just to use

one example.

I am not arguing. Maybe it should be. But the point is that there

is an anticipation by local governments and State governments for

some time that this would be forthcoming. We are changing that.

It seems to me that we need to send some mechanism here. I am

hearing you saying that with regard to these tax cuts, that the permanency of them, that you would like to see something put in

place, rather than just the pure permanency of them, some trigger

mechanism or some pay-as-you-go proposal that you attach to their

permanency.

Chairman GREENSPAN. Yes. I do not think that we can have permanent tax cuts or permanent spending programs in the sense that

they exist independently of the tax base or the revenue-raising

base of the economy.

In a sense, it would be desirable to have permanent, irrevocable

fiscal policy. But if it adds up to a claim on resources which exceeds what is available given our economic condition, something

has to give. So the notion of permanence cannot rationally be consistent with the programs we are involved with.

Senator DODD. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

Senator BUNNING. Thank you very much, Mr. Chairman.

I always start out just to ask one question of you. Do you see any

evidence of inflation in the economy presently?

Chairman GREENSPAN. I do not, Senator.

Senator BUNNING. Thank you. In regards to some of the testimony you have given in the past, I would like to just mention a

couple things that have happened since that testimony.

We had September 11, 2001. We have a war on terrorism. We

have had a surplus and now we have a deficit. We had a discussion

about the cost of the war, if there is one with Iraq, by OMB Director Mitch Daniels. He thinks the cost can be under $100 billion. I

heard a trillion dollars mentioned here just a minute ago.

What I am saying is for 40 years in the Congress that we had

some deficit spending. So before the year 1997, when we finally got

it right and we turned it around we then had some surplus years.

You testified that surpluses are not always good, but can create

problems. And sure enough, they have created a problem because

we got on a spending spree of about annually 10 to 12 percent in

discretionary spending. We cannot sustain that, Mr. Chairman,

and expect our surpluses to last very long.

24

Besides that, we have the cost of the war on terrorism and we

have the cost of the war for homeland security.

What I am saying to you is a temporary deficit in the amount of $300 billion is bad. I do not like it any more than you do. But

if we do not change the policies that we now have, we may have

that forever as we go out. And we have to change our fiscal policy

to deal with that.

Are you saying that we need to do that to stabilize our economy

in the out-years, even though you do not think that the tax cuts

are stimulus as they are now proposed?

Chairman GREENSPAN. I certainly think that it is crucial that we

have a budget policy which does not destabilize the economy. What

that turns out to be, Senator, amongst a number of different criteria, is at least the necessary condition that the level of debt-toGDP not be rising.

Now, you can have in today’s environment a level of debt-to-GDP

which is flat, but still have modest, small deficits, indeed, somewhere in the area of 1 to 2 percent. That is not inconsistent with

stability.

But if we get into a position, as I pointed out in my prepared remarks, where we are finding that the debt-to-GDP ratio begins to

accelerate, we have to be very careful because there is no selfequilibrating mechanism when that is occurring because a rise in

the debt increases the amount of interest payments, which in turn

increases the debt still further and there is an accelerating pattern

after you reach a certain point of no return.

So it is crucial that we keep in mind the long-term pattern of

debt-to-GDP on a unified basis. And I even go on further to discuss

in some detail the desirability of moving to an accrued budgetary

system as well, which would take into consideration the value of

the commitments which the Congress is making over a protracted

period and make judgments far better than we can now as to

whether those are long-term, sustainable fiscal policies.

Senator BUNNING. As you know, the Fed recently announced that

they will be eliminating 72 jobs from the Louisville office. I know

that your staff has assured my office that the Fed will try to help

those workers that are displaced. But I think those workers who

may be displaced would feel much better if they had assurance

from the Chairman that the Fed will do what they can to assist

them in finding new work. Will you give that commitment to the

Federal workers in Louisville and throughout the country who are

losing their jobs?

Chairman GREENSPAN. Most certainly, Senator. We have a program which endeavors either to find alternate jobs for the people

who are displaced in the check-clearing operations, or if that is not

feasible, to do whatever we can to find ways in which they can be

reemployed as expeditiously as possible.

Senator BUNNING. I have some other questions but my time has

run out. If I can, I will just submit them to you and you can give

me a written response.

Chairman GREENSPAN. I would be delighted to.

Senator BUNNING. Thank you.

Chairman SHELBY. Senator Reed.

Senator REED. Thank you, Mr. Chairman.

25

Chairman Greenspan, let me make one comment and then ask

one question.

In your testimony, you quite fervently argue for flexibility. But

one aspect of flexibility in the American economic and in the political system is the flexibility of leaders who recognize changed

circumstances. In fact, I think the President’s proposal is quite

inflexible. It is the same approach that he was advocating before

September 11. It is the same approach he was advocating before

we saw a surplus turn into a growing deficit. And I would hope

that if you are arguing for flexibility before the Congress, you

would argue for flexibility of mind with the Administration so that

they could adjust their policies.

Let me ask just one specific question. Actually, two premises and

a conclusion. I will ask you to comment on my premises and the

conclusion.

The first premise—the American public expects to be paid fully

the Social Security benefits which they have contributed.

The second premise—by exhausting the Social Security Trust

Fund, which is the effect, if not the intent, of the President’s proposals, accomplishing that expectation is very, very difficult, if not

impossible.

The conclusion might be, then, those who support these proposals

of the Administration either have no intention of paying fully the

benefits of Social Security, and I could add Medicare also, or they

are irresponsible in advocating such proposals.

Now the first premise. Do you believe that, not that the American people expect to have the benefits, we will in fact pay full Social Security benefits to everyone who is entitled at this moment?

Chairman GREENSPAN. I think, as best I can judge, it has always

been my expectation that the payments of benefits under law had

very little to do with what the assets in the Social Security Trust

Fund were, because I cannot conceive of a political situation in

which those benefits run out. And under law, there are curtailments in payments. I know that is what the law says. I have no

expectation that the Congress would allow that law to stay in

place.

Senator REED. The second premise is that, by exhausting the Social Security Trust Fund, which is the effect of the proposals that

we have seen 2 years ago in the tax cuts and the current proposals,

making those payments is extraordinarily difficult and will put extraordinary pressure on this Congress in terms of other programs

and other priorities. Do you agree with that premise, also?

Chairman GREENSPAN. Actually, the Social Security benefits are

reasonably capable of being estimated well into the future because

they have many of the characteristics of a defined benefit pension

plan. The really major fiscal problem is not Social Security. It is

Medicare.

Senator REED. I agree with you. However I was raising an issue

that is less complicated in terms of discretionary spending. But as

I think you recognize, and we all do, we are talking about, particularly after 2017, huge contingent liabilities which we can define

right now, as you said, we have reserved some funds for it. But we

are going to exhaust those funds by proposed tax cuts. Doesn’t it

follow then that we are making life impossible for us?

26

Chairman GREENSPAN. Well, I merely fall back to my previous

answer. These are the crucial issues of the determination of how

one allocates resources available to the Government amongst a series of programs, both tax and spending programs, all of which

have very strong supporters and very good re ́sume ́s, if I may put

it that way, as to why these programs are indispensable to the

American people.

It is the Congress’ very difficult task to make those judgments

because we have no other mechanism in this democratic society to

effectively try to translate the value system of the American people

into how we cut these priorities—I do not mean cutting, I mean by

paring—how we lay them out.

As you know, I was Chairman of the Social Security Commission

back in 1983. It was a fascinating experience to be exposed to a

number of what were then your predecessors in a number of the

seats around this table, on how they negotiated what ultimately actually turned out to be a remarkably sensible compromise. It

pleased nobody. But everyone signed on.

Senator REED. I think that is the only thing we can agree on. It

won’t please anybody what we do, but we have to do something.

Again, let me thank you. I see from your response, which is my

intuition also, that we will not step away from Social Security

spending, but we are going to make it extraordinarily difficult to

fulfill that commitment by these tax cuts.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sununu.

Senator SUNUNU. Thank you, Mr. Chairman.

Mr. Greenspan, in your testimony, you talk about the fact that

business inventories have stayed pretty lean and then indicate that

that is probably a good prognosticator of maybe future manufacturing activity, and note that purchasing manager information suggests the improvement on manufacturing activity has continued

into the beginning of this year. Could you elaborate on that a little

bit and talk about what signs you see from purchasing managers

or other sources that the early trends in the first quarter now are

somewhat positive?

Chairman GREENSPAN. Yes. First of all, the fact that inventories

are low is a very positive sign in the sense that if there is any evidence that the economy is picking up, inventory accumulation will

begin to move at a fairly pronounced pace.

The data for January, which we have, as you know, for purchasing managers, says that in their diffusion index, production

went up. But more importantly, we have a lot of weekly statistics

on production for motor vehicles, steel, electric power, and a set of

individual products which account for something in the area of a

sixth of the total industrial production index which we publish.

Senator SUNUNU. Is that a pretty good proxy?

Chairman GREENSPAN. Actually, it is better than a proxy in the

sense that we actually have on a weekly basis the industrial production index for part of the total.

Senator SUNUNU. But does the other 84 percent tend to track the

weekly numbers?

You can get weekly information on 50 percent. But if the other

50 percent is incredibly volatile, it may be of no use.

27

Chairman GREENSPAN. We have other indicators that tend to

proxy for the remainder, mainly, insured unemployment data,

which we find has been useful in combination with the weekly data

to suggest what patterns are emerging in the manufacturing or,

more exactly, in the industrial production area.

Senator SUNUNU. I consider myself somewhat an optimist. And

so, the parts of your testimony that, at least over the last 2 or 3

years, that I have found most interesting or most encouraging, is

your repetition of the degree to which you are impressed with the

resilience of our economy, the degree to which technological improvements have lent themselves to productivity increases and the

flexibility you talk about being important. Also, I have been impressed with the resilience of the consumer demand, which you

note in your testimony has been quite stable through all of this uncertainty. But business investment continues to lag.

Could you talk a little bit about the elements of the President’s

proposal that do target business investment? There is a provision

for small businesses to allow them to expense $75,000 a year instead of $25,000 a year.

To what degree is that kind of an approach effective, given that

it is targeted at small businesses? Are they a big enough part of

our business investment economy to make a difference?

I am not asking you to write legislation. I know that is not appropriate. But other types of approaches that might address the

lagging business investment and, as a result, have a good, longterm impact on our economy?

Chairman GREENSPAN. Senator, I have not looked at some of the

details enough to make an evaluation. But the most important

stimulus, if you want to put it that way, in my judgment, is the

removal of the uncertainties which overhang the capital investment

markets, which, as I have indicated earlier, I believe are quite significant and that one does not need stimulus, if I may put it that

way——

Senator SUNUNU. You are talking about the geopolitical concerns

that you outlined in your testimony.

Chairman GREENSPAN. Yes.

Senator SUNUNU. Beyond that, you have no thoughts to offer

about the accelerating depreciation or the reforming depreciation

schedules to encourage business investment? Or do you think they

just pale in comparison to the geopolitical concerns?

Chairman GREENSPAN. The answer is, yes, I do think that it is

small in comparison. But I have in the past discussed the various

different issues which economists have evaluated with respect to

capital investment, namely, there are ways to accelerate capital investment in the short run.

But the most fundamental stimulus to capital investment is the

prospect for higher earnings on real investment over the longer

run. There is no substitute.

Senator SUNUNU. I have one final question about the mortgage

industry.

You talked about the degree to which mortgage rates being at

historic lows encourage refinancing and the refinancing activity is

at a very high level right now.

28

In the past, you have been very candid about your concerns regarding the GSE’s and your thoughts regarding changing some of

the current legislation that provides benefits to GSE’s.

Let me talk about one particular reform, which I think is topical

because of the Sarbanes-Oxley bill, and that is greater oversight or

involvement of the SEC in the mortgage market and the secondary

mortgage markets in particular.

To what extent do you or would you support SEC oversight or

involvement in the GSE’s—but to what extent would that affect the

costs of mortgages and the liquidity in the mortgage markets?

Chairman GREENSPAN. Without stipulating whether I would

agree with any particular proposal because without seeing the specific proposal, basically saying that this agency should oversee this

part of the economy, I do not think there is enough information.

But having said that, the major issue here is the subsidy which

is implicit in the GSE debentures, even though they are not legally

an obligation of the U.S. Government. They are not backed by the

full faith and credit of the United States. It is the market which

presumes that they will be bailed out that effectively enables them

to sell mortgages at a number of basis points below what the market otherwise would be.

As a consequence of that, some of that does go through into lower

mortgage interest rates. But as best we can judge, it is a very

small number.

So, I am not at all convinced that many of the proposals really

make all that much difference to the secondary mortgage market

or to the level of mortgage interest rates to the American public.

Senator SUNUNU. I don’t want to let you completely off the hook.

On the first part of your response, it is the SEC, the Securities and

Exchange Commission, we do task them with oversight of securities markets. We are talking about collateralized obligations. Do

you think that they would be an appropriate oversight agency? Or

is there something unique to the mortgage markets that would

make you say that this has to be treated somewhat differently?

Chairman GREENSPAN. No, no. As you know, the SEC is already

involved in the question of making judgments as to whether certain

types of securities should be registered or not registered. I think

these are legally private corporations and should be handled the

way private corporations are handled.

Senator SUNUNU. With regard to registration and fees.

Chairman GREENSPAN. With regard to issues that revolve around

the SEC. But going beyond that, I do not know because I do not

know what the particular proposals would be.

Senator SUNUNU. I appreciate that. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Schumer.

Senator SCHUMER. Thank you, Mr. Chairman. And I want to

thank you for your answers.

I would like to refer, Mr. Chairman, to an exchange that you and

I had just about 2 years ago that still rings fresh in my mind. And

it rings fresh in my mind because it was cited in The Washington

Post today, evidently.

As you may recall, you appeared before our Committee in 2001,

as we were considering the President’s first tax cut package and its

29

potential impact on dividends. And I am just going to quote a little

bit of our exchange:

SCHUMER: I take it you, Chairman Greenspan, would say deficit reduction is a

reasonable priority.

GREENSPAN: I would say, Senator, that we do not wish to go back into unified

budget deficits.

SCHUMER: Right.

Okay. That sounds like me.

[Laughter.]

SCHUMER: So the question is, given the numbers that you have been talking

about, when do we get to a level where it is too high?

GREENSPAN: I repeat—when we project our way back into deficit, which I think

would be a mistake.

That is pretty unequivocal.

Now according to the Congressional Budget Office, and validated

by the President’s own budget and advisors, we are going to have

a unified deficit of $199 billion in 2003, and unified deficits through

2007. If we exclude the Social Security Trust Fund surplus, all of

those figures are worse and the budget remains in deficit through

2011.

To me, this passes the test of, as you put it, projecting our way

back into deficits. So given this new budget outlook, do you maintain, as you stated a while ago, that a large tax cut that further

sends us into deficits, would be a mistake?

Chairman GREENSPAN. I support the program to reduce double

taxation on dividends and the necessary other actions in the Federal budget to make it revenue-neutral.

Senator SCHUMER. Right.

Chairman GREENSPAN. I think that that would be a significant

value to the American economic system.

Senator SCHUMER. Okay. Let me just probe your fertile mind.

I generally like cutting the tax on dividends in an abstract world.

All things being equal, not thinking of the deficit, it seems to me

something that would be a good idea. Although I think I agree with

you that it probably would have more bang for the buck in a sense

at the corporate level than at the individual level.

So be it. I am not President and making that decision.

But one way we could make it revenue-neutral, and not get into

the age-old fight between the spending side because you and I

know that with war coming and with everything else, we are not

going to make up for that huge revenue loss that the dividend tax

cut would produce on spending.

Even the President’s budget goes up 4 percent. It doesn’t go up

as much as maybe it might have. And I know the President is trying to rein in spending, but it still goes up. It doesn’t do anything

to balance the dividend tax cut.

What about looking at some corporate tax loopholes. Give something to the corporate side, but take it away. Give it in a general

and nonspecific way, which is generally preferred in tax theory.

The Cato Institute, not an organization I always agree with, but

they said that Federal subsidies to business costs taxpayers an estimated $87 billion a year. These are the rifle shots aimed at very

specific businesses or specific industries.

Congressional Research says that corporate tax expenditures are over $100 billion. And most troubling to me, offshore tax havens—

30

and I have a proposal which is different. I would like the shareholders to vote before the company goes offshore.

If this is supposed to benefit the company, let’s see if the shareholders have that view, which I think is a little bit unpatriotic that

we should go overseas to reduce our revenues. But in any case, these offshore tax havens cost an estimated $92

billion in otherwise taxable profits. So those are enormous figures—$3 trillion in lost revenues over 10 years, which would pay,

of course, for the dividend reduction, the dividend elimination,

eliminating the tax on dividends several times over.

It has been a tough issue to address politically. But do you think

that combining these two things might be—I am not asking you to

comment on any of the specific proposals I mentioned, but general

corporate reform, and then come out in a much more revenue neutral way, but still do the tax elimination on dividends and given

general corporations a break, a good idea?

Chairman GREENSPAN. Senator, I have always opposed subsidies

to corporations. If you are a private business, you should function

as a private business and getting special preferences from the Federal Government has never been something which I have been supportive of.

Senator SCHUMER. So, you might think that combining the two,

in the abstract, would be a good idea.

Chairman GREENSPAN. I do not want to comment on the specifics

of your proposal.

Senator SCHUMER. All right. I tried. I do not know. Is my time

up, Mr. Chairman?

Chairman SHELBY. Your time is up.

Senator SCHUMER. Okay. Well, I have more questions.

Chairman SHELBY. Senator Dole.

Senator DOLE. Chairman Greenspan, I would like you to focus on

the long-term effects of very low-interest rates. With the Federal

funds rate at a record low and the high rate of mortgage refinancing, do you see a long-term problem with future mortgagebacked securities which will yield historically low returns?

Chairman GREENSPAN. There is no necessary problem that mortgage-backed securities are in difficulty with low-interest rates in

the sense, remember that these securities are fully backed by

whole mortgages and in many respects, because they are so-called

conforming mortgages, they have reasonably good credit ratings.

Indeed, it is really interesting to observe that even though the

loans are on individual properties, they have something close to an

‘‘A’’ rating individually and in total. So, unless there is something

I am missing in your question, Senator, I have not been concerned

about the level of interest rates as such.

There are questions that are involved in the size of the secondary

mortgage market and its efficiency and how it functions. I think

the movement of interest rates, and low-interest rates, do cause

some problems for some of the GSE’s as a consequence of that.

Because there is a one-sided option where a homeowner can refinance, but the bank cannot, at its will, refinance, you have difficulties in knowing what the maturity of these particular mortgages

are which combined into any form of these collateralized vehicles.

And I suspect there are some difficulties with them.

31

So far, that market has worked really quite well. And indeed, I

would even go further. I would say the ability to have been able

to get the extent of refinancing which has reduced the debt service

charges for the American homeowner, but also the very large cashouts, which is borrowing over and above just refinancing the mortgage, has been a very important issue in financing consumers in

maintaining a fairly robust consumer market, which I think has

been a major factor helping us through the last 2 years of very difficult problems with the corporate investment and inventory sectors.

Senator DOLE. Thank you. Two other questions, please.

Wholesale heating oil prices jumped enormously. Yesterday, it was up 30 cents from a week earlier to $1.20 a gallon. Do you have

any information on what may happen if indeed there is a conflict

with Iraq, whether others in OPEC might step up and fill the

shortfall?

Chairman GREENSPAN. Senator, this is a very crucial question

which we in the Federal Reserve watch very closely and obviously,

other members of the Government are doing the same.

There are problems in the sense that the sum of the capacity of

Iraq and Venezuela is greater than the gap between overall world

oil capacity and presumed consumption. And it is that which has

been driving up crude oil prices which has spilled over into home

heating oil. But it has been very considerably exacerbated by the

obviously colder-than-expected winter that we have gone through.

We have gone through certain calculations which suggest that inventory levels which seem to be quite low at the primary distributor level, have actually moved up quite considerably in both

households and in the secondary distribution level, so that there

has been a bulge in heating oil inventories which we do not directly

measure.

This cannot continue on, obviously, because we are gradually

moving out of the heating season and into effectively a much lower

level of aggregate world demand for oil, which is between the

North American heating season and the motoring season, which

dominates world markets.

In that regard, the outlook, other than the impact of a war, is

really obviously quite favorable.

The crucial question here is whether, in a war, that the Iraqi oil

fields are under stress. So without being able to forecast for both

the final outcome of the problems in Venezuela, which has cut production from about 3 million barrels a day down to now a little

over one million barrels a day, and the Iraqi oil production capability, so long as those issues overhang us, they will continue to

press prices higher. But the fundamentals are for much lower

prices, eventually.

Senator DOLE. Thank you.

Mr. Chairman, my mother is 101 years old. America is aging, as

we all know. We will have a savings crunch in the next 20 years.

I would like to have your thoughts on what we might do to increase

savings and what you think of the President’s proposals in this regard.

Chairman GREENSPAN. About half of productivity growth in the

United States is attributable to the actual capital investment input

32

which we make year upon year, and that is a prominent force in

productivity. It is not 100 percent, but it is a very big chunk.

The more savings that we have that are productively used in our

economy, the greater the productivity, the greater the growth, the

greater the prosperity that we have. Any proposal which augments

savings has a positive effect on long-term economic growth.

I cannot comment on the specifics of the President’s proposal because it is rather complex and there are pluses and there are

minuses, and I probably would be better off if I just stayed with

that for the moment.

But we should keep looking for policies which, one, enhance savings and enhance flexibility. I think there has been too much in the

way of trying to do short-term stimuluses and they work in the

short run, but then they fade out. And I think we spend more time

than I think is productive in figuring out how to get the economy

to move in a certain way in the very short run, rather than focus

on the long-term. And if we do that, I suspect the short-term will

largely take care of itself.

Senator DOLE. Thank you.

Chairman SHELBY. Senator Bayh.

Senator BAYH. Thank you to both Chairmen.

Mr. Chairman, I have four questions. So, I am going to try to

march through these relatively succinctly.

The first is about the proposal and the double taxation of dividends. I understand the argument in favor of it. It is that it will

promote more flexibility in the economy, increase productivity

growth, and thereby, better prepare us for the advent of the retirement of the baby-boom generation.

As you know, there are many things that affect productivity

growth. I remember well in my previous capacity as Governor, your

giving an address to the Governors Association about the effect of

job training and education on productivity growth. There are other

things, such as investment in research and development. There are

other parts of the tax code that could be altered that would stimulate productivity gains.

Why is this the best proposal of all the possible avenues to promote productivity growth? And is there a comparative analysis that

we can rely on in making this policy decision?

Chairman GREENSPAN. Senator, I do not know the answer to that

question. I do know that eliminating the double taxation of dividends is a positive force for just the reasons you gave.

I cannot say to you that I know that say using the same amount

of resources, if you want to put it that way, it is the best because

nobody has come up with a proposal which strikes me as better.

I do not deny that one could.

Senator BAYH. Unfortunately, that is the choice that we face.

My second question is about the effect of tax cuts on revenues.

A couple of years ago, the tax cut that was enacted into law was

advanced as a way to reduce the burgeoning size of the surplus by

reducing the amount of revenue coming into the Federal Treasury.

Today, an acceleration of those same tax cuts is being urged

upon us. I understand not by you because you have questions about

the need for a stimulus at this point. But as a way to stimulate

33

the economy, to grow revenue, and thereby deal with the budget

surplus.

How do you reconcile these arguments coming from the same

people? How can the same policy both increase and decrease revenues?

Chairman GREENSPAN. As you say, you are not addressing that

question to me.

[Laughter.]

Senator BAYH. Well, someone needs to answer it because it is

being pressed upon us, and it seems to me to be internally inconsistent. But I will go on to my third question.

You mentioned a combination of weak demand plus continuing

productivity gains has led to a soft job market. All of us want the

productivity gains to continue. In your opinion, what level of

growth is necessary to create jobs in a climate where robust productivity gains continue?

Chairman GREENSPAN. It is a strictly arithmetical calculation because, basically, jobs or, more exactly, hours of input, plus the

change in productivity, is what gives you the GDP.

What we had for a good part of last year was a largely unexploited capability of a manufacturing and distribution system and

service system, which basically had not been pressed through the

latter part of the 1990’s to be as efficient as it could.

Remember, back in the latter part of the 1990’s, the real issue

was to try to expand markets, expand sales, and expand profitability as a consequence. And little relative effort was employed in

making sure that the costs involved in producing those expanding

outputs were as efficient as they could be.

When we came into the early 2000’s, where sales became very

sluggish, American business turned to that unexploited source of

potential productivity and created a remarkable run-up in output

per hour.

So long as that unexploited base is there, then it is possible for

business to continuously increase output with very little increase in

employment.

Now, I do not know where the point turns. At some point, that

availability of unexploited short-term capability to increase productivity will have been exhausted, and then to keep up with demand

which is coming in, presumably, you have to start reemploying lots

of people. And I do not know where that is, but it will happen, and

presumably, sooner rather than later.

Senator BAYH. And the more that we can do to increase demand

and grow GDP, the sooner that day would arrive.

Chairman GREENSPAN. Oh, certainly. For every percentage point

increase in the GDP growth rate, holding productivity growth unchanged, is the same percentage——

Senator BAYH. I promise, Chairman Shelby, this will be quick,

Mr. Chairman. So let me just cut to the bottom line of my fourth

question.

I have only been around this town for 4 years. But I think a

healthy level of skepticism is in order when it comes to the Federal

Government’s ability to constrain—take the difficult steps necessary to constrain the budget deficit. Ordinarily, the thing grows

34

until it can be denied no longer, a crisis is imminent, then something is done.

Having said that, I want to ask you about the double taxation

again. Assuming for the sake of argument, that these deficits are

going to persist for a while, does the benefit of flexibility and productivity generated by ending the double taxation of dividends outweigh the exacerbation of the deficit that it may cause?

Chairman GREENSPAN. Well, I presume that it will not cause an

exacerbation because I would couple my consideration of this with

the restoration of the PAYGO rules. So, I look at that as a joint

recommendation.

Senator BAYH. Thank you, Mr. Chairman. It is one that hopefully

we can implement.

Mr. Chairman, thank you.

Chairman SHELBY. Thank you.

Senator Miller.

Senator MILLER. Mr. Chairman, thank you for your wisdom and

also, as I note the clock, thank you for your patience this morning.

My first question is one that I am bringing from Young Harris,

Georgia. I was sitting around a coffee table in this rural Georgia

restaurant. We were discussing the President’s economic program

and his plan, and the fact that it suggests that the deficit is going

to rise. And the way that it was put to me was, does the growth

in the deficit pose a greater or lesser danger than the prospect of

slower economic growth?

I told them that I did not know the answer, but that I would ask

Chairman Greenspan, which impressed them and let me get out of

that restaurant.

[Laughter.]

Senator SARBANES. Give the Chairman the name of the restaurant so he can go down there and visit it himself.

[Laughter.]

Senator MILLER. Mary Anne’s.

Chairman SHELBY. Mary Anne’s.

[Laughter.]

Chairman GREENSPAN. The basic approach to economic analysis

and programming that is associated with it is, in my judgment, to

try to formulate a budget policy which is stable, meaning that it

does not create pressures on private finance which eliminates the

underlying growth pattern in the economy.

So, I would presume that we can have a fairly rapidly growing

economy with a balanced budget or even a surplus, and that the

presumption that deficits somehow would increase the GDP—the

more deficit, the greater the GDP—is a short-term view which I do

not believe continues in the longer run.

I think we have to focus on maintaining maximum economic

growth, but simultaneously recognize that a necessary condition to

do that is that deficits have to be contained or, at the extreme, that

the ratio of debt to the public as a percent of the GDP, remains

stable.

Senator MILLER. Thank you. I will try to paraphrase that next

Saturday.

[Laughter.]

35

This also is a question that comes from personal experience. I am

sitting here between two former governors. I do not know about

them, but from time to time, I get to thinking that maybe it would

be better to be back in the Statehouse. Except right now, it is not

too good back in the Statehouse.

My question to you is, do you think that Congress should address

in any way the budget shortfalls that the States are having? And

if so, what would be your approach?

Chairman GREENSPAN. This is a difficult question largely because the source of the problem in many of the States, as you

know, Senator, has been that with the fairly substantial surge in

revenues that the States had in many cases, and it is hard to know

how many, permanent programs for expenditures were financed.

And to a large extent, because the tax rate on capital gains and

options and the like are—or I should say the tax rate on capital

gains in the States are pretty much equivalent to the regular income tax rate since the adjusted gross income from the Federal returns is what is used for the income tax where it is applicable for

the States, we saw a very big surge in Federal revenues, but for

some States, because the tax rates are relatively high, they saw an

even greater surge.

So that you have to weigh the fact that some of the States overexpended and should and will and are appropriately pulling back,

and others did not. And the question is, how does the Congress or

the Federal Government appropriately handle that without essentially treating those who were not sufficiently conservative to contain their funds from those who are less conservative? In other

words, how does one make a program which is fair to everybody?

I have no objection obviously to having Federal funds go to the

States. We have been doing that for decades. But I must admit

that I do have some problems—how would one in all fairness create

a program which did not essentially benefit those who are the least

conservative in their programs relative to those who were more

conservative? If that can be done, then I think that there are obvious arguments in favor of it.

Senator MILLER. Thank you, sir.

Chairman SHELBY. Senator Carper.

Senator CARPER. Mr. Chairman, again thanks for all of your time

and insights today.

I want to follow up on Governor Miller’s and Governor Bayh’s

questions with one that also relates to the States.

We have heard from the States repeatedly over the last year or

two that, particularly for those whose tax systems piggybacked on

the Federal system, that when we make reductions here, then

there is an effect on them as well, reducing their revenue base.

With the latest proposal from the Administration, and which I

think in theory, the double taxation of dividends make sense. It is

logical.

I, like you, would say, if we are going to do that thing in the context of maybe a broader tax reform, that it be deficit-neutral and

that we do it on the corporate side rather than on the approach

that the Administration seems to be taking.

But I am hearing from some of my old governor friends that they

are concerned about the cost of issuing tax-exempt debt and how

36

that might be affected, if we approach the taxation of dividends as

the Administration has proposed.

Any thoughts as to how we could minimize the effect of the impact on the States by taking a different course?

Chairman GREENSPAN. Senator, you are referring to the issue

that municipal finance, the interest rates that are involved would

be affected by essentially creating a whole new segment of demand

for untaxable issues, so to speak.

Senator CARPER. Yes, sir.

Chairman GREENSPAN. This is a half-full, half-empty glass problem because the double taxation of dividends is a subsidy to the

municipalities in the sense that it gives them less competition and,

hence, better financing capability.

If you look at it that way, then the question is you are eliminating a subsidy. If you look at it the other way, you are taking

away a subsidy which is deserved. And I do not have a clue how

to answer that question.

Senator CARPER. All right. Let us try another one. I am going to

quote you here in your written testimony, which says:

The intensification of geopolitical risks makes discerning the economic path ahead

especially difficult. If these uncertainties diminish considerably in the near term, we

should be able to tell far better whether we are dealing with the business sector

and an economy poised to grow more rapidly—our more probable expectation—or

one that is still laboring under persisting strains and imbalances that have been

misidentified as transitory.

And then, skipping down a couple of lines, you say:

If instead, contrary to our expectations, we find that, despite the removal of the

Iraq-related uncertainties, constraints to expansion remain, various initiatives for

conventional monetary and fiscal stimulus will doubtless move higher on the policy

agenda.

There is a couple of different ways a person could read this.

My own view is that the greatest impediment to economic growth

in this country is the uncertainties, a lot of them outside of our

country. But I alluded to some of those earlier.

Are you saying here that before we use the other arrows in our

monetary arrow-holder——

Senator MILLER. Quiver.

Senator CARPER. Quiver—out of our monetary quiver, or out of

our fiscal quiver, that we should first try to deal with some of these

uncertainties. And once we have dealt with those, then let us see

what we further need to do on the monetary side or the fiscal side.

Is that what you are saying?

Chairman GREENSPAN. Yes, Senator.

Senator CARPER. On the monetary side, what could that include?

Chairman GREENSPAN. The usual monetary policy initiatives.

Senator CARPER. Well, you have done a lot. And there are some

on this Committee who have been rather critical of your stewardship on monetary policy. I am certainly not among them. But what

further can we do? You have taken the Federal funds rate down.

You have loosened up the money supply. What further is there to

do?

Chairman GREENSPAN. Well, the general position of the Federal

Open Market Committee at this particular stage is that we are

holding at the 11⁄4 percent Federal funds rate and view the outlook

37

as the balance of risks essentially balanced on both the upside and

the downside.

One of the reasons is the large uncertainties with respect to the

geopolitical risks. As I said several times this morning, our judgement, as best as we can make it, is that there seems to be a fairly

significant, almost inexorable, endeavor on the part of the economy

to move forward, but it is being held back by these set of forces.

And if that is the correct interpretation, and we are viewing it

correctly, then we will find that, at least in my judgment, the issue

of the discussion of stimulus will probably just go away. Because

of the fact we are apt to know the resolution of that within a period

which doesn’t stretch out indefinitely into the future, I have concluded, as I have indicated previously here, that we are probably

more sensible to wait to see what happens before we embark upon

a number of programs which may in fact from a stimulus point of

view, not be necessary.

Remember that I am in support of the President’s program on

the elimination of the double taxation of dividends, not for shortterm stimulus purposes. I think that it is a very sensible long-term

program.

Senator CARPER. Thank you.

Chairman SHELBY. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman.

Chairman Greenspan, I want to be precise if I can. You said that

you support President Bush’s proposal, which I just heard you say,

about the dividend exclusion. But I also heard you say, only if it

were implemented in a revenue-neutral world. Does that mean, to

be clear, would you oppose the Bush tax plan if it were not offset

with regard to the dividend exclusion?

Chairman GREENSPAN. I would just allow my remarks to stand

as I have stated them.

Senator CORZINE. You do believe it should be revenue-neutral?

Chairman GREENSPAN. I do believe it should be revenue-neutral.

Senator CORZINE. I presume that, if we cannot put that together,

the conclusion is clear.

Let me say, in light of changed conditions that we have talked

about, Senator Dodd asked a question about making permanent the

2001 tax cuts. And I thought I heard that in light of changed conditions, you believed in triggers, sunsets, and reviews, those policies

in light of those changed circumstances. Did I hear that as it related to the 2001, making permanent the 2001 tax cuts?

Chairman GREENSPAN. Yes. I went further. I thought I said that

I did not believe that there can be in this changed fiscal environment, with so much in the way of commitments to the longer term,

which are entitlements, that there can be such a concept as an unchangeable program on either the revenue or the expenditure side.

Senator CORZINE. Thank you.

Following up on some of the questions that the Governors talked

about, is a $70 to $90 billion cumulative budget deficit at the State

levels, maybe larger if you include some of the local government

levels, a drag on economic activity, regardless of what we do here,

if that is what takes place, cutting in expenditures or raising taxes,

181⁄2 percent in the city of New York or property taxes?

38

Chairman GREENSPAN. Senator, as you know, it relates solely to

the general funds of the States and does not affect really the localities or other parts of the State budgets that are involved. So those

numbers are really quite large. But they are variable. And our ability to forecast them has not been particularly good.

But, having said that, to the extent that taxes are raised in order

to close those gaps, I would assume that it is restrictive of economic activity in the locality.

Senator CORZINE. Thank you.

I just wanted to make sure that I heard you say deficits impact

long-term interest rates, in your view, and have an impact then on

the investment function over a period of time.

Chairman GREENSPAN. You heard me correctly, sir.

Senator CORZINE. Okay. Then I would just ask, is there any

time—you have a wealth of knowledge on this—in economic history

that you know of a period in time when we are at war, where we

have serious programmatic demands with regard to homeland security and protecting the American people and our national security

needs, that you have seen a series of tax cuts in the judgment of

Congress, is the right way to proceed fiscally?

Chairman GREENSPAN. Well, Senator, that is a factual question

which it is either true or it is false. And I presume that we can

find that out.

There is one point in this discussion, however, that I think we

should at least put on the table. It is that the ratio of defense expenditures to the GDP is still quite low and indeed, as recently as

a couple of years ago, it was at the lowest level since before World

War II.

So, we do have a low base from which we are functioning. And

one would presume that there is some give there.

Now that does not respond specifically to your question with respect to whether tax cuts are appropriate or not appropriate. But

it is relevant to the general impact of what the size of potential demands, at least for the military, would be relative to the overall

economy.

Senator CORZINE. I would understand that. But it does have an

ultimate budget impact on the bottom line of whether we are running deficits and national savings is being impacted by the fact of

the role of Government, whether it is for national security or

whether it is for domestic policy.

Chairman GREENSPAN. That is certainly the case. But in the context of raising it with the issue of being in periods of war or in periods of military stress, those periods, you will find the ratio of

defense expenditures-to-GDP was considerably higher than it is

today.

Senator CORZINE. You talked about flexibility in the economy and

then were complimentary of Sarbanes-Oxley.

I would presume that there are times when you believe that the

role of Government in our society is a positive element. Some people might call that rigidity and the imposition of rigidities with

respect to flexibility. So that there is some minimum level of participation that I would suspect that you are supportive of with regard to the SEC and other elements.

39

Chairman GREENSPAN. I think that I have a very rigid view toward the Constitution of the United States. I do not wish to imply,

Senator, that I believe that flexibility goes into our laws or any of

the other things which affect business decisionmaking and business

activity and corporate governance.

Clearly, you cannot run a flexible, capitalist, ‘‘creative destruction’’ type of economy unless you have a rule of law which is clear,

unequivocal, and definitive. And in that regard, that is not flexible.

In other words, flexible law may very well lead to rigid economics.

Senator CORZINE. Thank you.

Chairman SHELBY. Senator Stabenow.

COMMENTS OF SENATOR DEBBIE STABENOW

Senator STABENOW. Thank you, Mr. Chairman. And Chairman

Greenspan, welcome back to the Committee.

One more follow-up regarding State budget deficits because we

know that across the country now, the vast majority of the States

are in serious deficits or gaps in their funding.

The National Council of State Legislatures says in the coming

year, over $68 billion will be there in terms of shortfalls.

From a macroeconomic view, can you speak to the effect again

in terms of large fiscal shortfalls and the macroeconomic effect to

the country?

Chairman GREENSPAN. Well, Senator, because, I gather, with the

exception of Vermont, every State has a requirement that the

budget be balanced within the State, the actions that are going to

be taken by the States in order to meet their internal statutes or

constitutions are going to be taken well before the Congress can decide to move significant funds for the current year.

Those adjustments are going to be taken. And one must presume,

although I do not know this, that it will effectively restore balance

into the States well before any funding could be made available to

the States.

If that is the case, then you have to be careful in thinking about

this issue because unless taxes which are raised which would have

a macroeconomic negative effect, are then presumed to be lowered

again as Federal funds come in, which strikes me as questionable

policy, then I think you have to recognize that because the timing

of when the fiscal years end in the States tends to be different than

our fiscal year in the Federal Government, you have a very tricky

problem, in that if the States have to take actions in order to close

their budget deficits in this fiscal year before any Federal funds

could conceivably be forthcoming, and in that process, they actually

close the gap for all subsequent years, then the issue of making

Federal funds available to help the States over this particular problem tends to be moot.

And I do not know what the answer to that is. You have to, I

suspect, argue that even if they were to impose taxes or cut programs in order to maintain their constitutional required balance,

that there are still problems for the current fiscal year which could

be assisted by Federal funds.

In that event, as I indicated to Senator Miller, you could make

the argument that one could go forward with programs, but it is

next year’s concerns that should be of interest to you, not the curVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00043 Fmt 6633 Sfmt 6633 90930.TXT SBANK4 PsN: SBANK4
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rent ones, because it is already too late to address those issues in

most States, as I understand it.

Senator STABENOW. I appreciate that. I know that in Michigan,

that is certainly the case, although they are projected for 2004 additional either spending that will be eliminated from the economy

in the State, or some other combinations in terms of—certainly,

States are looking at raising taxes, taking spending out of the economy, and so on. I would suspect that this is going to be a few years

of a challenge for the States.

If you might talk one more time about the deficit.

Senator Bayh, Senator Snowe, and I and others have been, since

2001, talking about a trigger and put forward both in committee

and on the floor the idea of both addressing an economic trigger

that dealt with tax and spending programs so that we would not

be going back into debt.

Two years ago, we were talking about tremendous surpluses and

whether or not we should go back into debt. Now, we are talking

about how big the deficit will be, dramatically different just in 2

years. It is astounding the shift that we have seen. But I know you

have spoken in support of the idea of some kind of a trigger that

relates to the deficit.

And also, before the Committee back in February 2001, when we

talked about that, you had said: ‘‘If there were a trigger which

were built into both tax and spending programs, to the extent that

they were phased, it ensures that we achieve what I think should

be the first priority—namely, to eliminate the debt.’’

I would ask both if you continue to support the idea of a trigger

to bring us into balance, but also, do you still believe that eliminating the debt should be our first priority?

Chairman GREENSPAN. With the revenues where they are, or

more exactly the tax base, where it currently is, that is no longer

feasible as a realistic priority.

I was raising it in the context of when we were getting significantly higher individual income tax receipts as a consequence of a

very high flow of cash which the Congressional Budget Office was

projecting would maintain us in a very high surplus level for quite

a while.

If we could eliminate the debt in a practical way which was conceivable at that point, I would certainly be in favor of it. But having lost the base and, indeed, largely because of the sharp decline

in the stock market, a very substantial amount of revenues have

been pulled out of the system, it is not a credible policy which we

can embark upon without very substantially altering revenues and

spending in a way which I do not think the Congress would even

remotely consider.

So it was a practical consideration back then. Regrettably, that

is gone without it being achieved.

Senator STABENOW. It is extremely regrettable. And when we

look at the slowing of the economy, the issues of terrorism and the

war certainly have to be taken into account. But I would argue

that, unfortunately, a majority was self-inflicted by decisions that

were made by the Congress.

Just one other quick question if I might, Mr. Chairman, that is

a totally separate track.

41

Chairman Greenspan, I know that the Federal Reserve is exempted from the appropriations process. I would like to talk about

the SEC, just one question.

I know that you are allowed to use whatever funds are collected.

There are reasons for that in terms of insulating you from political

pressure, being able to make long-term decisions, being able to

make decisions independently, and so on, all of which makes sense

to me.

I am wondering if you believe that the SEC, which is one of the

only major regulators that goes through the appropriations process,

might be better served and if investors and Americans would be

better served if in fact the SEC funding process was, as your funding process is, exempt from the annual appropriations process.

I wonder if you have any thoughts on that.

Chairman GREENSPAN. I have no specific thoughts on that general proposal, Senator. But I have always argued that it has been

our experience that the levels of the salaries in the SEC are probably too low, especially for their lawyers, to attract the quality of

people in general which they need to maintain the type of surveillance which is required.

They have some extraordinary lawyers in the SEC whom I suspect could be making double to three times what they are making

in the private sector.

Senator STABENOW. Don’t tell them that, would you?

Chairman GREENSPAN. No, they are smart enough to know that.

Senator STABENOW. I agree.

Chairman GREENSPAN. But they consider working at the SEC a

sufficiently interesting job to consider that the foregone income is

more than matched than the job appreciation that one has from

doing that work.

Senator STABENOW. Thank you.

Chairman SHELBY. Chairman Greenspan, I am going to try to be

quick. I have a lot of questions for the record, such as the President’s budget, projected deficits, tax reform, personal savings—

some of these things have been touched on. Dividend proposals

have been touched on. Condition of the banking industry, the

economy’s resilience, and so forth.

But we will do those for the record. I will try to be real fast and

try to wind this up. I know you have a place to go and you need

to get there.

Would you elaborate quickly on the types of decisions regarding

our tax structure that would increase economic flexibility as well

as the long-run growth potential that the changes would create?

Chairman GREENSPAN. Senator, the first thing I would do would

be to broaden the question to overall fiscal policy.

Chairman SHELBY. Okay.

Chairman GREENSPAN. As I indicated earlier, I think we are now

involved in the type of process which is really quite different from

anything we had in the past. It is essentially the fact that we are

dealing with long-term entitlements or taxes which do not go

through annual appropriations or annual evaluations by the Congress, and as a consequence of that, can very readily add up to a

drain on the resources of the economy, which is not the intention

of the Congress.

42

So, I think that the process really needs to be thoroughly reviewed to make it consonant with the fact of our long-term commitments. And that would be involved with accrual accounting, which

I discuss at length in my prepared remarks. It has to do with the

triggers and various other mechanisms to enable a phase-in of programs which will go off-track inevitably, so that they do not create

instabilities in the fiscal system.

We must be sure that the Federal Government does not impinge

on the private sector’s capability of creating goods and services and

expanding the standard of living of the American people, and that

requires that it not drain the savings resources of the private sector, which it does when it is running a deficit.

Chairman SHELBY. Last, would you comment on the effect of the

strengthened Euro versus the dollar on the U.S. economy? What is

the future of that?

Chairman GREENSPAN. Well, unfortunately, I am not capable of

answering that because, as I think I may have said to you previously in hearings, that we have an agreement with the Treasury

that the exchange rate is discussed only by the Secretary of the

Treasury and by no one else in the Administration.

Chairman SHELBY. We will have Secretary Snow up here as soon

as Senator Sarbanes and I can.

Chairman GREENSPAN. I would suggest that you raise that question with him and you will get a sensible answer.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Mr. Chairman, I just have one question that

I want to ask Chairman Greenspan.

Just last year, you testified before the JEC, and I quote you:

It is difficult to predict how long global investors will continue to place their funds

disproportionately in U.S. assets. The current account is a measure of the increase

in net claims, primarily debt claims that foreigners have on our assets. As the stock

of such claims grows, an ever larger flow of interest payments must be provided to

the foreign suppliers of this capital.

Countries that have gone down this path invariably have run into trouble, and

so would we.

And in your monetary policy report, you point out that we are already borrowing $500 billion a year from a broad, a record 5 percent of our GDP. I have been concerned about this issue, as you

know from some of our exchanges, for a very long time. This is the

net international position of the U.S. as a percent of GDP.

A little over 20 years ago, we were positive, 12.9 percent of GDP.

Now, we are negative, just shy of 23 percent of GDP. And if we had

5 percent this next year because of the continued borrowing, we

would be down to 28 percent of GDP. Is it really realistic to expect

that these big increases in our Federal deficit can be offset even

more by foreign borrowing? What kind of hole are we digging ourselves into here?

Chairman GREENSPAN. Senator, I think I probably said at the

JEC testimony, to which you are alluding, and in years previous

when this issue came up, that that trend cannot continue. Something will make it change.

What is basically causing it is the fact that we have a propensity

to import goods and services relative to our GDP which is by far

higher than our trading partners’. So in the context of everybody

in the world growing at the same rate, we would continually inVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00046 Fmt 6633 Sfmt 6633 90930.TXT SBANK4 PsN: SBANK4
43

crease our imports faster than anybody else and create a large and

increasing trade deficit, which of course is at the root of this particular problem.

We know that at some point, the system cannot go on because,

as you point out in one of the balance sheets in the way our economy functions is, of necessity, that there are relationships between

the Government deficit, domestic investment, and domestic savings

which are all tied together. And they cannot go off in different directions without affecting each other.

I presumed 5 years ago that it would be resolved at some point.

I have been presuming the same thing every year for 5 years. Fortunately, we have not had a major problem with respect to this

because the productivity in the United States has been very impressive and the rates of return on our assets have attracted a considerable amount of investment.

There are a numbers of ways in which this adjustment could

occur. One, which we hope is the case, is a gradual adjustment

process which is essentially incremental and we restore balance

without economic disruption.

There are other scenarios in which there are disruptions. I do not

know of any useful way—I know of no way that I find persuasive

that enables us to look at this particular process and be able to

forecast when the adjustment is going to occur. But far more importantly, how it is going to occur. And that it will occur I think

is inevitable.

Chairman SHELBY. Any other questions?

[No response.]

Mr. Chairman, picking up on this, on the current account, how

much of that is attributable, our deficiency in the current account,

to the importation of oil?

You can furnish that for the record.

Chairman GREENSPAN. It is an issue, but it is not the critical

issue.

Chairman SHELBY. It is not the only issue, is it?

Chairman GREENSPAN. No. We import much more oil per dollar

of GDP than others. But in and of itself, even without the oil, that

problem still exists.

Chairman SHELBY. It would exist, but it wouldn’t be exacerbated.

Is that true?

Chairman GREENSPAN. Obviously, we are increasing an ever-increasing proportion of our domestic consumption of oil, we are importing an increasing proportion, and that clearly has no offsets.

Chairman SHELBY. Mr. Chairman, thank you for your appearance. Thank you for your patience and your answers.

The hearing is adjourned.

[Whereupon, at 12:45 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

44

PREPARED STATEMENT OF SENATOR ELIZABETH DOLE

Thank you, Mr. Chairman. I want to thank you for holding this hearing, and I

join you in welcoming Federal Reserve Chairman Greenspan today for his Semi-Annual Monetary Policy Report. Chairman Greenspan, over the years the economy has

benefited greatly from your leadership at the Federal Reserve. In these uncertain

times, experience and steadiness at the helm of the central bank are particularly

important. We are grateful for your continued service.

In recent months, we have witnessed some mixed messages from our economic indicators. I was pleased to see that last month unemployment fell three-tenths of a

percent from December and that home sales and residential construction remain at

high levels. However, at the same time, rising energy costs place a strain on the

economy and adverse weather has harmed agricultural production.

The Federal Reserves’ January Current Market Conditions Report quoted a Charlotte, North Carolina, contact which summed up conditions in commercial real estate sector as ‘‘slow to partly cloudy.’’

With these issues in mind, my colleagues and I look forward to your thoughts on

the current state of the economy and its potential. In addition, I hope we have the

benefit of your views regarding the President’s tax package and its ability to stimulate the economy. I know you agree that tax stimulus is a necessary component of

economic recovery, and I look forward to hearing your thoughts on this.

While all of us agree that the American economy needs a push in the right direction there is some disagreement among my colleagues on the best way to achieve

this goal. I hope in the months ahead we can work together to take the necessary

steps in the right direction. Your report today will help us focus on the fundamentals as we move forward.

Chairman Greenspan, I look forward to working with you and the Federal

Reserve in the years to come to achieve sustainable long-term growth.

Thank you, Mr. Chairman.

—————

PREPARED STATEMENT OF SENATOR PAUL S. SARBANES

I am pleased to welcome Chairman Greenspan before the Committee on Banking,

Housing, and Urban Affairs this morning to testify on the Federal Reserve’s SemiAnnual Monetary Policy Report to Congress.

Yesterday, a statement signed by over 450 economists, including 10 Nobel Prize

winners, was released. At the outset of today’s hearing I think it would be worthwhile to read parts of that statement because it helps to frame the economic issues

that will be under discussion this morning:

Economic growth, although positive, has not been sufficient to generate

jobs and prevent unemployment from rising. In fact, there are now more

than two million fewer private sector jobs than at the start of the current

recession. Overcapacity, corporate scandals, and uncertainty have and will

continue to weigh down the economy.

The tax cut plan proposed by President Bush is not the answer to these

problems. Regardless of how one views the specifics of the Bush plan, there

is wide agreement that its purpose is a permanent change in the tax structure and not the creation of jobs and growth in the near-term. The permanent dividend tax cut, in particular, is not credible as a short-term

stimulus. As tax reform, the dividend tax cut is misdirected in that it targets individuals rather than corporations, is overly complex, and could be,

but is not, part of a revenue-neutral tax reform effort.

Passing these tax cuts will worsen the long-term budget outlook, adding

to the Nation’s projected chronic deficits.

When President Bush came into office in January 2001, the Federal Government

had a projected 10-year surplus of $5.6 trillion. In fact, Chairman Greenspan, you

testified before the Senate in favor of the tax cut proposed by the President at that

time on the grounds that the Government was paying off its debt too fast. You argued that a tax cut was needed to ‘‘smooth the glide path,’’ I believe that was the

phrase you used, so that the Government debt would not be paid off too quickly and

put the Government in the position of acquiring private assets.

That is not the problem we confront today. If the President’s program were enacted into law, the budget projection for the same 10-year period would be a $2.1

trillion deficit. That is a $7.7 trillion reversal. That does not include the costs of a

possible war with Iraq. It also does not include tax changes such as the reform of

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45

uled to sunset which have traditionally been extended. That projection may well be

overly optimistic.

By any measure, we are in the process of transforming the fiscal position of the

United States from one of fiscal surplus to one of large fiscal deficits. Given the

scale of the deficits that would be created by the President’s plan, fundamental

questions are raised about the impact of deficits on interest rates, investment,

growth, and jobs in our economy.

The Administration is downplaying the impact of budget deficits, arguing the deficits that will result from their program are not that large relative to the economy,

and that their size will be reduced by the economic activity that will result from

the enactment of its proposed tax cuts. Some people who now support these tax cuts,

and discount the significance of the budget deficits they would produce, previously

supported an amendment to the Constitution requiring a balanced budget. Particularly in the face of the uncertain demands on public resources imposed by the war

on terrorism, homeland defense, difficulties with North Korea, and a possible war

with Iraq, I believe the President’s proposals are reckless and irresponsible.

Giving away our economic strength with the kind of irresponsible tax cuts proposed by the President would not only deny us the public resources we will need

to meet future challenges, but also it would put upward pressure on long-term interest rates that would reduce economic growth and impose greater hardship on middle

and working class Americans.

I look forward to reviewing these issues with Chairman Greenspan this morning.

—————

PREPARED STATEMENT OF SENATOR TIM JOHNSON

Chairman Shelby and Ranking Member Sarbanes, thank you for convening today’s hearing to examine the monetary policy of the United States. We are privileged to have before us Chairman Alan Greenspan, and I welcome him here today

to the Senate Banking Committee.

Today, as we gather to hear about the state of America’s economy, we face a grim

picture. It is sobering to note that, just 2 years ago, Chairman Greenspan cautioned

this Committee about the dangers of paying down the national debt too quickly.

Now just a short time later, we face a $304 billion deficit this year alone, and a

deficit of more than $2 trillion over the next 10 years.

In 2001, I voted to support President Bush’s $1.3 trillion tax cut. While I wish

that package had been less skewed to the richest Americans, I agree with Chairman

Greenspan, who has often warned that the Government should not accumulate

taxpayer dollars. At the time I voted for tax relief, this country faced historically

high surpluses of $5.6 trillion for fiscal years 2002–2011, and I committed myself

to returning surplus funds to the taxpayers. I did so, however, on the condition that

President Bush himself reiterated during his State of the Union address: ‘‘We will

not pass along our problems to other Congresses, other Presidents, other generations.’’

It is difficult to believe that our circumstances have changed so dramatically since

President Bush took office 2 short years ago. And it is even more difficult to believe

that President Bush appears determined to do exactly the opposite of what he

pledged not to: Pass along our actions to the next generation.

Frankly, I am appalled at the President’s recklessness in proposing a massive tax

cut targeted for the rich while so many of our Nation’s basic needs go unmet. I simply cannot understand the impulse to plunge our Nation into even more staggering

deficits in order to indulge the desire for massive tax relief for the rich. All this,

Mr. Chairman, while denying that we leave the next generation to pay for this folly.

I believe that any stimulus plan must meet three simple conditions: (1) it should

give tax relief to working American families who need it and who will spend it; (2)

it should give tax relief now, while the economy is weak; and (3) it should not saddle

our children and grandchildren with additional debt. President Bush’s plan does not

meet these conditions. Instead, President Bush uses his plan as an excuse not to

provide real stimulus, like drought relief that is so desperately needed in States like

South Dakota.

Chairman Greenspan has long been respected for his wise counsel on the damaging impact of deficits. It is now conventional wisdom that deficits cause high interest rates, and that, as Mr. Greenspan testified back in 2001, ‘‘a declining level

of Federal debt is desirable because it holds down long-term real interest rates,

thereby lowering the cost of capital and elevating private investment.’’ We need only

look at the incredible appreciation in the Nation’s housing market to see the real

benefits that low interest rates have had on our economy.

46

Back in 2001, when we were faced with record surpluses, I think that we all recognized the value of Chairman Greenspan’s suggestion that the President’s tax cut

include so-called ‘‘triggers’’ to revisit the revenue side if the projected budget surpluses did not materialize. He recognized that political pressure tends to make hard

decisions even harder.

Today, it is my hope that Chairman Greenspan can resist the strong pressure to

allow politics to color his testimony. We have all read articles decrying the last election cycle as one of the most vicious in history, with ads attacking our colleagues’

patriotism, their judgment, their motives. For the sake of our Nation and its fiscal

health, we must not let that ugliness infect our current deliberations. Chairman

Greenspan, your legacy deserves to reflect the brilliance of your career to this point.

And so it all comes down to this: Will you be remembered for maintaining your opposition to reckless deficit spending? Or will you abandon that legacy by succumbing

to enormous political pressure to justify the President’s tax proposal.

I look forward to your testimony.

—————

PREPARED STATEMENT OF ALAN GREENSPAN

CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

FEBRUARY 11, 2003

Mr. Chairman and Members of the Committee, I am pleased this morning to

present the Federal Reserve’s Semi-Annual Monetary Policy Report to the Congress.

I will begin by reviewing the state of the U.S. economy and the conduct of monetary

policy and then turn to some key issues related to the Federal budget.

When I testified before this committee last July, I noted that, while the growth

of economic activity over the first half of the year had been spurred importantly by

a swing from rapid inventory drawdown to modest inventory accumulation, that

source of impetus would surely wind down in subsequent quarters, as it did. We at

the Federal Reserve recognized that a strengthening of final sales was an essential

element of putting the expansion on a firm and sustainable track. To support such

a strengthening, monetary policy was set to continue its accommodative stance.

In the event, final sales continued to grow only modestly, and business outlays

remained soft. Concerns about corporate governance, which intensified for a time,

were compounded over the late summer and into the fall by growing geopolitical

tensions. In particular, worries about the situation in Iraq contributed to an appreciable increase in oil prices. These uncertainties, coupled with ongoing concerns

surrounding macroeconomic prospects, heightened investors’ perception of risk and,

perhaps, their aversion to such risk. Equity prices weakened further, the expected

volatility of equity prices rose to unusually high levels, spreads on corporate debt

and credit default swaps deteriorated, and liquidity in corporate debt markets declined. The economic data and the anecdotal information suggested that firms were

tightly limiting hiring and capital spending and keeping an unusually short leash

on inventories. With capital markets inhospitable and commercial banks firming

terms and standards on business loans, corporations relied to an unusual extent on

a drawdown of their liquid assets rather than on borrowing to fund their limited

expenditures.

By early November, conditions in financial markets had firmed somewhat on reports of improved corporate profitability. But on November 6, with economic performance remaining subpar, the Federal Open Market Committee chose to ease the

stance of monetary policy, reducing the Federal funds rate 50 basis points, to 11⁄4

percent. We viewed that action as insurance against the possibility that the still

widespread weakness would become entrenched. With inflation expectations well

contained, this additional monetary stimulus seemed to offer worthwhile insurance

against the threat of persistent economic weakness and unwelcome substantial declines in inflation from already low levels.

In the weeks that followed, financial market conditions continued to improve, but

only haltingly. The additional monetary stimulus and the absence of further revelations of major corporate wrongdoing seemed to provide some reassurance to investors. Equity prices rose, volatility declined, risk spreads narrowed, and market

liquidity increased, albeit not to levels that might be associated with robust economic conditions. At the same time, mounting concerns about geopolitical risks and

energy supplies, amplified by the turmoil in Venezuela, were mirrored by the worrisome surge in oil prices, continued skittishness in financial markets, and substantial uncertainty among businesses about the outlook.

Partly as a result, growth of economic activity slowed markedly late in the summer and in the fourth quarter, continuing the choppy pattern that prevailed over

47

the past year. According to the advance estimate, real GDP expanded at an annual

rate of only 3⁄4 percent last quarter after surging 4 percent in the third quarter.

Much of that deceleration reflected a falloff in the production of motor vehicles from

the near-record level that had been reached in the third quarter when low financing

rates and other incentive programs sparked a jump in sales. The slowing in aggregate output also reflected aggressive attempts by businesses more generally to ensure that inventories remained under control. Thus far, those efforts have proven

successful in that business inventories, with only a few exceptions, have stayed

lean—a circumstance that should help support production this year. Indeed, after

dropping back a bit in the fall, manufacturing activity turned up in December, and

reports from purchasing managers suggest that improvement has continued into

this year. Excluding both the swings in auto and truck production and the fluctuations in nonmotor-vehicle inventories, economic activity has been moving up in a

considerably smoother fashion than has overall real GDP: Final sales excluding

motor vehicles are estimated to have risen at a 21⁄4 percent annual rate in the

fourth quarter after a similar 13⁄4 percent advance in the previous quarter and an

average of 2 percent in the first half.

Thus, apart from these quarterly fluctuations, the economy has largely extended

the broad patterns of performance that were evident at the time of my July testimony. Most notably, output has continued to expand, but only modestly. As previously, overall growth has simultaneously been supported by relatively strong

spending by households and weighed down by weak expenditures by businesses. Importantly, the favorable underlying trends in productivity have continued; despite

little change last quarter, output per hour in the nonfarm business sector rose 33⁄4

percent over the four quarters of 2002, an impressive gain for a period of generally

lackluster economic performance. One consequence of the combination of sluggish

output growth and rapid productivity gains has been that the labor market has remained quite soft. Employment turned down in the final months of last year, and

the unemployment rate moved up, but the report for January was somewhat more

encouraging.

Another consequence of the strong performance of productivity has been its support of household incomes despite the softness of labor markets. Those gains in

income, combined with very low interest rates and reduced taxes, have permitted

relatively robust advances in residential construction and household expenditures.

Indeed, residential construction activity has moved up steadily over the year. And

despite the large swings in sales, the underlying demand for motor vehicles appears

to have been well maintained. Other consumer outlays, financed partly by the large

extraction of built-up equity in homes, have continued to trend up. Most equity extraction—reflecting the realized capital gains on home sales—usually occurs as a

consequence of house turnover. But during the past year, an almost equal amount

reflected the debt-financed cash-outs associated with an unprecedented surge in

mortgage refinancings. Such refinancing activity is bound to contract at some point,

as average interest rates on outstanding home mortgages converge to interest rates

on new mortgages. However, fixed mortgage rates remain extraordinarily low, and

applications for refinancing are not far off their peaks. Simply processing the backlog of earlier applications will take some time, and this factor alone suggests that

refinancing originations and cash-outs will be significant at least through the early

part of this year.

To be sure, the mortgage debt of homeowners relative to their income is high by

historical norms. But as a consequence of low interest rates, the servicing requirement for the mortgage debt of homeowners relative to the corresponding disposable

income of that group is well below the high levels of the early 1990’s. Moreover,

owing to continued large gains in residential real estate values, equity in homes has

continued to rise despite sizable debt-financed extractions. Adding in the fixed costs

associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be

a significant cause for concern at this time.

While household spending has been reasonably vigorous, we have yet to see convincing signs of a rebound in business outlays. After having fallen sharply over the

preceding 2 years, new orders for capital equipment stabilized and, for some categories, turned up in nominal terms in 2002. Investment in equipment and software

is estimated to have risen at a 5 percent rate in real terms in the fourth quarter

and a subpar 3 percent over the four quarters of the year.

However, the emergence of a sustained and broad-based pickup in capital spending will almost surely require the resumption of substantial gains in corporate

profits. Profit margins apparently did improve a bit last year, aided importantly by

the strong growth in labor productivity.

48

Of course, the path of capital investment will depend not only on market conditions and the prospects for profits and cashflow but also on the resolution of the

uncertainties surrounding the business outlook. Indeed, the heightening of geopolitical tensions has only added to the marked uncertainties that have piled up

over the past 3 years, creating formidable barriers to new investment and thus to

a resumption of vigorous expansion of overall economic activity.

The intensification of geopolitical risks makes discerning the economic path ahead

especially difficult. If these uncertainties diminish considerably in the near term, we

should be able to tell far better whether we are dealing with a business sector and

an economy poised to grow more rapidly—our more probable expectation—or one

that is still laboring under persisting strains and imbalances that have been

misidentified as transitory. Certainly, financial conditions would not seem to impose

a significant hurdle to a turnaround in business spending. Yields on risk-free Treasury securities have fallen, risk spreads are narrower on corporate bonds, premiums

on credit default swaps have retraced most of their summer spike, and liquidity conditions have improved in capital markets. These factors, if maintained, should eventually facilitate more-vigorous corporate outlays.

If instead, contrary to our expectations, we find that, despite the removal of the

Iraq-related uncertainties, constraints to expansion remain, various initiatives for

conventional monetary and fiscal stimulus will doubtless move higher on the policy

agenda. But as part of that process, the experience of recent years may be instructive. As I have testified before this Committee in the past, the most significant lesson to be learned from recent American economic history is arguably the importance

of structural flexibility and the resilience to economic shocks that it imparts.

I do not claim to be able to judge the relative importance of conventional stimulus

and increased economic flexibility to our ability to weather the shocks of the past

few years. But the improved flexibility of our economy, no doubt, has played a key

role. That increased flexibility has been in part the result of the ongoing success

in liberalizing global trade, a quarter-century of bipartisan deregulation that has

significantly reduced rigidities in our markets for energy, transportation, communication, and financial services, and, of course, the dramatic gains in information

technology that have markedly enhanced the ability of businesses to address festering economic imbalances before they inflict significant damage. This improved

ability has been facilitated further by the increasing willingness of our workers to

embrace innovation more generally.

It is reasonable to surmise that, not only have such measures contributed significantly to the long-term growth potential of the economy this past decade, they also

have enhanced its short-term resistance to recession. That said, we have too little

history to measure the extent to which increasing flexibility has boosted the economy’s potential and helped damp cyclical fluctuations in activity.

Even so, the benefits appear sufficiently large that we should be placing special

emphasis on searching for policies that will engender still greater economic flexibility and dismantling policies that contribute to unnecessary rigidity. The more

flexible an economy, the greater its ability to self-correct in response to inevitable,

often unanticipated, disturbances, thus reducing the size and consequences of cyclical imbalances. Enhanced flexibility has the advantage of adjustments being automatic and not having to rest on the initiatives of policymakers, which often come

too late or are based on highly uncertain forecasts.

Policies intended to improve the flexibility of the economy seem to fall outside the

sphere of traditional monetary and fiscal policy. But decisions on the structure of

the tax system and spending programs surely influence flexibility and thus can have

major consequences for both the cyclical performance and long-run growth potential

of our economy. Accordingly, in view of the major budget issues now confronting the

Congress and their potential implications for the economy, I thought it appropriate

to devote some of my remarks today to fiscal policy. In that regard, I will not be

emphasizing specific spending or revenue programs. Rather, my focus will be on the

goals and process determining the budget and on the importance, despite our increasing national security requirements, of regaining discipline in that process.

These views are my own and are not necessarily shared by my colleagues at the

Federal Reserve.

* * *

One notable feature of the budget landscape over the past half century has been

the limited movement in the ratio of unified budget outlays-to-nominal GDP. Over

the past 5 years, that ratio has averaged a bit less than 19 percent, about where

it was in the 1960’s before it moved up during the 1970’s and 1980’s. But that pattern of relative stability over the longer term has masked a pronounced rise in the

49

1 Unfortunately, they are incomplete steps because even a 10-year horizon ends just as the

baby-boom generation is beginning to retire and the huge pressures on Social Security and especially Medicare are about to show through. 2 In particular, a full set of accrual accounts would give the Congress, for the first time in

usable form, an aggregate tabulation of Federal commitments under current law, with various

schedules of the translation of those commitments into receipts and cash payouts. 3 However, accrued outlays should exhibit far less deterioration than the unified budget outlays when the baby boomers retire because the appreciable rise in benefits that is projected to

cause spending to balloon after 2010 will have been accrued in earlier years. 4 Constraining these outlays by any mechanism other than prices will involve some form of

rationing—an approach that in the past has not been popular in the United States.

share of spending committed to retirement, medical, and other entitlement programs. Conversely, the share of spending that is subject to the annual appropriations process, and thus that comes under regular review by the Congress, has been

shrinking. Such so-called discretionary spending has fallen from two-thirds of total

outlays in the 1960’s to one-third last year, with defense outlays accounting for almost all of the decline.

The increase in the share of expenditures that is more or less on automatic pilot

has complicated the task of making fiscal policy by effectively necessitating an extension of the budget horizon. The Presidents’ budgets through the 1960’s and into

the 1970’s mainly provided information for the upcoming fiscal year. The legislation

in 1974 that established a new budget process and that created the Congressional

Budget Office required that organization to provide 5-year budget projections. And

by the mid-1990’s, CBO’s projection horizon had been pushed out to 10 years. These

longer time periods and the associated budget projections, even granted their imprecision, are useful steps toward allowing the Congress to balance budget priorities

sensibly in the context of a cash-based accounting system.1 But more can be done

to clarify those priorities and thereby enhance the discipline on the fiscal process.

A general difficulty concerns the very nature of the unified budget. As a cash accounting system, it was adopted in 1968 to provide a comprehensive measure of the

funds that move in and out of Federal coffers. With a few modifications, it correctly

measures the direct effect of Federal transactions on national saving. But a cash

accounting system is not designed to track new commitments and their translation

into future spending and borrowing. For budgets that are largely discretionary,

changes in forward commitments do not enter significantly into budget deliberations, and hence the surplus or deficit in the unified budget is a reasonably accurate

indicator of the stance of fiscal policy and its effect on saving. But as longer-term

commitments have come to dominate tax and spending decisions, such cash accounting has been rendered progressively less meaningful as the principal indicator of the

state of our fiscal affairs.

An accrual-based accounting system geared to the longer horizon could be constructed with a reasonable amount of additional effort. In fact, many of the inputs

on the outlay side are already available. However, estimates of revenue accruals are

not well developed. These include deferred taxes on retirement accounts that are

taxable on withdrawal, accrued taxes on unrealized capital gains, and corporate tax

accruals. An accrual system would allow us to keep better track of the Government’s

overall accrued obligations and deferred assets. Future benefit obligations and taxes

would be recognized as they are incurred rather than when they are paid out by

the Government.2

Currently, accrued outlays very likely are much greater than those calculated

under the cash-based approach. Under full accrual accounting, the Social Security

program would be showing a substantial deficit this year, rather than the surplus

measured under our current cash accounting regimen.3 Indeed, under most reasonable sets of actuarial assumptions, for Social Security benefits alone past accruals

cumulate to a liability that amounts to many trillions of dollars. For the Government as a whole, such liabilities are still growing.

Estimating the liabilities implicit in Social Security is relatively straightforward

because that program has many of the characteristics of a private defined-benefit

retirement program. Projections of Medicare outlays, however, are far more uncertain even though the rise in the beneficiary populations is expected to be similar.

The likelihood of continued dramatic innovations in medical technology and procedures combined with largely inelastic demand and a subsidized third-party payment

system engenders virtually open-ended potential Federal outlays unless constrained

by law.4 Liabilities for Medicare are probably about the same order of magnitude

as those for Social Security, and as is the case for Social Security, the date is rapidly

approaching when those liabilities will be converted into cash outlays.

Accrual-based accounts would lay out more clearly the true costs and benefits of

changes to various taxes and outlay programs and facilitate the development of a

50

5Office of Management and Budget, Budget of the United States Government, fiscal year 2004,

Washington, DC: U.S. Government Printing Office, p.32. 6 In general, fiscal systems are presumed stable if the ratio of debt in the hands of the publicto-nominal GDP (a proxy for the revenue base) is itself stable. A rapidly rising ratio of debtto-GDP, for example, implies an ever-increasing and possibly accelerating ratio of interest payments to the revenue base. Conversely, once debt has fallen to zero, budget surpluses generally

require the accumulation of private assets, an undesirable policy in the judgment of many.

broad budget strategy. In doing so, these accounts should help shift the national

dialogue and consensus toward a more realistic view of the limits of our national

resources as we approach the next decade and focus attention on the necessity to

make difficult choices from among programs that, on a stand-alone basis, appear

very attractive.

Because the baby boomers have not yet started to retire in force and accordingly

the ratio of retirees to workers is still relatively low, we are in the midst of a demographic lull. But short of an outsized acceleration of productivity to well beyond the

average pace of the past 7 years or a major expansion of immigration, the aging

of the population now in train will end this state of relative budget tranquility in

about a decade’s time. It would be wise to address this significant pending adjustment sooner rather than later. As the President’s just-released budget put it, ‘‘The

longer the delay in enacting reforms, the greater the danger, and the more drastic

the remedies will have to be.’’ 5

Accrual-based revenue and outlay projections, tied to a credible set of economic

assumptions, tax rates, and programmatic spend-out rates, can provide important

evidence on the long-term sustainability of the overall budget and economic regimes

under alternative scenarios.6 Of course, those projections, useful as they might

prove to be, would still be subject to enormous uncertainty. The ability of economists

to assess the effects of tax and spending programs is hindered by an incomplete understanding of the forces influencing the economy.

It is not surprising, therefore, that much controversy over basic questions surrounds the current debate over budget policy. Do budget deficits and debt significantly affect interest rates and, hence, economic activity? With political constraints

on the size of acceptable deficits, do tax cuts ultimately restrain spending increases,

and do spending increases limit tax cuts? To what extent do tax increases inhibit

investment and economic growth or, by raising national saving, have the opposite

effect? And to what extent does Government spending raise the growth of GDP, or

is its effect offset by a crowding out of private spending?

Substantial efforts are being made to develop analytical tools that, one hopes, will

enable us to answer such questions with greater precision than we can now. Much

progress has been made in ascertaining the effects of certain policies, but many of

the more critical questions remain in dispute.

However, there should be little disagreement about the need to reestablish budget

discipline. The events of September 11 have placed demands on our budgetary resources that were unanticipated a few years ago. In addition, with defense outlays

having fallen in recent years to their smallest share of GDP since before World War

II, the restraint on overall spending from the downtrend in military outlays has

surely run its course—and likely would have done so even without the tragedy of

September 11.

The CBO and the Office of Management and Budget recently released updated

budget projections that are sobering. These projections, in conjunction with the

looming demographic pressures, underscore the urgency of extending the budget

enforcement rules. To be sure, in the end, it is policy, not process, that counts. But

the statutory limits on discretionary spending and the so-called PAYGO rules, which

were promulgated in the Budget Enforcement Act of 1990 and were backed by a

sixty-vote point of order in the Senate, served as useful tools for controlling deficits

through much of the 1990’s. These rules expired in the House last September and

have been partly extended in the Senate only through mid-April.

The Budget Enforcement Act was intended to address the problem of huge unified

deficits and was enacted in the context of a major effort to bring the budget under

control. In 1990, the possibility that surpluses might emerge within the decade

seemed remote indeed. When they unexpectedly arrived, the problem that the

budget control measures were designed to address seemed to have been solved. Fiscal discipline became a less pressing priority and was increasingly abandoned.

To make the budget process more effective, some have suggested amending the

budget rules to increase their robustness against the designation of certain spending

items as ‘‘emergency’’ and hence not subject to the caps. Others have proposed

mechanisms, such as statutory triggers and sunsets on legislation, that would allow

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7 In fact, we will need some further acceleration of productivity just to offset the inevitable

decline in net labor force, and associated overall economic, growth as the baby boomers retire.

track—as they invariably will. These ideas are helpful and they could strengthen

the basic structure established a decade ago. But, more important, a budget framework along the lines of the one that provided significant and effective discipline in

the past needs, in my judgment, to be reinstated without delay.

I am concerned that, should the enforcement mechanisms governing the budget

process not be restored, the resulting lack of clear direction and constructive goals

would allow the inbuilt political bias in favor of growing budget deficits to again

become entrenched. We are all too aware that Government spending programs and

tax preferences can be easy to initiate or to expand but extraordinarily difficult to

trim or to shut down once constituencies develop that have a stake in maintaining

the status quo.

In Congress’s review of the mechanisms governing the budget process, you may

want to reconsider whether the statutory limit on the public debt is a useful device.

As a matter of arithmetic, the debt ceiling is either redundant or inconsistent with

the paths of revenues and outlays you specify when you legislate a budget.

In addition, a technical correction in the procedure used to tie indexed benefits

and individual income tax brackets to changes in ‘‘the cost of living’’ as required by

law is long overdue. As you may be aware, the Bureau of Labor Statistics has recently introduced a new price index—the so-called chained CPI. The new index is

based on the same underlying data as is the official CPI, but it combines the individual prices in a way that better measures changes in the cost of living. In particular, the chained CPI captures more fully than does the official CPI the way that

consumers alter the mix of their expenditures in response to changes in relative

prices. Because it appears to offer a more accurate measure of the true cost of

living—the statutory intent—the chained CPI would be a more suitable series for

the indexation of Federal programs. Had such indexing been in place during the

past decade, the fiscal 2002 deficit would have been $40 billion smaller, all else

being equal.

At the present time, there seems to be a large and growing constituency for holding down the deficit, but I sense less appetite to do what is required to achieve that

outcome. Reestablishing budget balance will require discipline on both revenue and

spending actions, but restraint on spending may prove the more difficult. Tax cuts

are limited by the need for the Federal Government to fund a basic level of services—for example, national defense. No such binding limits constrain spending. If

spending growth were to outpace nominal GDP, maintaining budget balance would

necessitate progressively higher tax rates that would eventually inhibit the growth

in the revenue base on which those rates are imposed. Deficits, possibly ever widening, would be the inevitable outcome.

Faster economic growth, doubtless, would make deficits far easier to contain. But

faster economic growth alone is not likely to be the full solution to currently projected long-term deficits. To be sure, underlying productivity has accelerated considerably in recent years. Nevertheless, to assume that productivity can continue to

accelerate to rates well above the current underlying pace would be a stretch, even

for our very dynamic economy.7 So, short of a major increase in immigration, economic growth cannot be safely counted upon to eliminate deficits and the difficult

choices that will be required to restore fiscal discipline.

By the same token, in setting budget priorities and policies, attention must be

paid to the attendant consequences for the real economy. Achieving budget balance,

for example, through actions that hinder economic growth is scarcely a measure of

success. We need to develop policies that increase the real resources that will be

available to meet our longer-run needs. The greater the resources available—that

is, the greater the output of goods and services produced by our economy—the easier

will be providing real benefits to retirees in coming decades without unduly restraining the consumption of workers.

* * *

These are challenging times for all policymakers. Considerable uncertainties surround the economic outlook, especially in the period immediately ahead. But the

economy has shown remarkable resilience in the face of a succession of substantial

blows. Critical to our Nation’s performance over the past few years has been the

flexibility exhibited by our market-driven economy and its ability to generate substantial increases in productivity. Going forward, these same characteristics, in concert with sound economic policies, should help to foster a return to vigorous growth

of the U.S. economy to the benefit of all our citizens.

52

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY

FROM ALAN GREENSPAN

Q.1. I would like to start off with a very broad question involving

our tax structure. I am a strong proponent of a simplified tax structure which would eliminate the inefficiencies of our current system

and end the waste of the vast resources currently dedicated to taking advantage of all of the complexities.

What three words would you use to describe our current system?

What would be the benefits of moving to a more straightforward

structure? What aspects of our current tax structure would be in

the ‘‘most in need of reform’’ winners?

A.1. I believe that our current tax system is overly complex, burdensome, and inefficient. It creates larger disincentives for work,

saving, and investment than need be to raise the revenue required

to finance Government operations. Moreover, the complexity leads

to a substantial commitment of resources on the part of the private

sector for the sole purpose of complying with the tax code. The Nation would be well served by moving to a more straightforward

structure that would engender greater economic flexibility and efficiency and lower the compliance burden. A successful round of tax

reform, particularly with regard to the taxation of capital income,

could significantly improve the working of our economy. As I stated

in my recent appearance before the Committee, I believe any such

tax reform should be implemented in a budget-neutral manner.

Q.2.a. The President’s budget proposes an end to the double taxation of corporate dividends by granting tax relief to individual

shareholders. I support this proposal and the President’s proposal

to increase expensing for small businesses. What would you anticipate would be the effect of these proposals on investment and job

growth?

A.2.a. A full analysis of the macroeconomic impact of the proposals

is exceptionally complicated because the relevant conceptual issues

touch on unsettled questions at the heart of public finance and corporate finance. That said, as I pointed out during my testimony, I

support elimination of the double taxation of dividends because it

is good long-term policy that reduces distortions and adds to the

flexibility of the economy in responding to shocks that otherwise

might result in recession. While I do not support elimination of

double taxation because of short-term stimulus, it likely would provide some near-term boost to the economy. This is primarily because the plan would likely boost the level of stock prices that, in

turn, would generate a positive wealth effect; there also could be

some small income effects owing to short-run multiplier effects on

aggregate demand.

Q.2.b. Won’t this proposal give corporations better incentives as

they decide whether to issue debt or equity to run their operations?

A.2.b. If enacted as proposed, the President’s plan would eliminate

the double tax on corporate dividends and those capital gains derived from undistributed after-tax profits (‘‘deemed’’ dividends).

This would eliminate shareholder taxes on corporate equity income

and thus mitigate the current tax-induced distortion that favors

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porate dividends and capital gains would boost the incentive to

issue equity, both to finance new investment and to pay down existing debt, resulting in a decline in corporate debt-equity ratios.

As a positive byproduct, the diminution of the reliance on debt

would tend to reduce the fragility of the financial system in the

face of adverse shocks.

Q.2.c. Some have argued that it would be preferable to allow corporations to expense dividends akin to the treatment of interest.

Does it matter how we do it? And if it does, what incentives/disincentives and costs/benefits are created based on the two approaches?

A.2.c. I would prefer that the elimination of the double taxation of

dividends be done at the corporate level, although in the long run,

it probably would not matter greatly which approach is taken. I

would note a couple of differences, however, between the two approaches you outline. First, if the plan were implemented on the

corporate side, the revenue loss likely would be larger, because

about half of dividends are received by tax-exempt equity holders

at the personal level. Second, the increase in share prices may be

larger: When implemented on the corporate side, the stream of dividend payments plausibly would rise essentially immediately and,

thus, make stocks more attractive even to tax-exempt holders.

Q.3.a. The President’s budget projects deficits through 2008. Some

have expressed concern about the magnitude of these deficits. However, on a percentage basis, the deficits are a smaller percentage

of GDP than those we experienced in the 1980’s. (For example, the

projected $308 billion deficit for 2003 represents 2.8 percent of

GDP while the 1992 deficit was 4.7 percent of GDP.) Given current

economic conditions and uncertainty concerning world affairs, how

important is it to maintain fiscal discipline and where is it most

important to seek this discipline?

A.3.a. Current economic and fiscal circumstances make the maintenance of fiscal discipline highly important. The recently updated

budget projections from CBO and the Office of Management and

Budget show that projections of the budget balance have deteriorated sharply over the past 2 years reflecting, in part, the demands

that our response to the events of September 11 has placed on our

budgetary resources, as well as the effects on tax revenues of the

cyclical downturn and stock market decline. This return to budget

deficits has occurred at a time when lower deficits and declining

Federal debt levels would help the country prepare for the fiscal

pressures that will accompany the rapidly approaching retirement

of the baby-boom generation.

My preferred approach to attaining fiscal discipline would be to

reinstate budget rules—perhaps a version of the recently expired

PAYGO rules and discretionary spending caps. Such an approach

would leave the Congress and the Administration free to act on

high-priority initiatives and respond to unanticipated demands as

long as their effect on the deficit were offset elsewhere in the budget. In addition, I have frequently stated that improvement in the

budget balance realized through spending restraint would generally

be preferable to improvements based on tax increases.

54

Q.3.b. At what point do you believe we should be concerned about

Government deficits ‘‘crowding out’’ private borrowing?

A.3.b. The tendency for increases in the deficit to crowd out private

borrowing does not begin at a particular point. In general, increases in the deficit result in higher long-term interest rates

which, in turn, discourage private borrowing. However, if we let

deficits become too large there is the additional concern that the

fiscal system will become unsustainable; that is, higher-debt service outlays engendered by growing debt may result in a cycle of

ever-higher debt-service outlays and deficits relative to GDP. Such

instability would not occur as long as deficits do not result in a rising debt-to-GDP ratio. The path of the debt-to-GDP ratio currently

being projected by CBO and the Office of Management and Budget

for the next several years is about flat; that is, the deficits do not

yet pose a significant instability concern. But as we go beyond the

turn of the decade, a very significant acceleration in payments to

beneficiaries of both Social Security and Medicare will hit the

budget and, in the absence of other budget adjustments, produce

deficit-to-GDP ratios that would not be consistent with long-run fiscal sustainability.

Q.4. The threat of war against Iraq leaves consumers and businesses feeling very uncertain about the economic outlook. I want to

ask you about an article from last week’s Wall Street Journal. According to this article, since WWII, wartime spending has become

a smaller part of the economy and produces fewer economic gains.

In short, the article makes the case that the United States cannot

expect an economic boost from war-related spending since the economy has grown so large relative to the spending. Given that is the

case, should we be arguing that the threat of war represents a significant factor in the cooldown or lag in the economy? What other

factors might be at work that are not receiving attention?

A.4. It is certainly the case that defense spending represents a

smaller share of our GDP than it did in the 1950’s and 1960’s; that

is also true for the share of defense output in manufacturing production. However, I would still expect the incremental increases in

defense spending over previously budgeted levels to boost the level

of real activity, at least in the short to intermediate term. Part of

that effect is likely to occur right away. However, the boost to production from the replacement of spent munitions and equipment

would likely extend over several years. That was the pattern we

saw after the 1991 Gulf War.

In more recent months, geopolitical concerns have been among a

number of factors inhibiting business hiring and capital spending.

There is considerable anecdotal evidence that business remain in

a wait-and-see mode when it comes to dealing with geopolitical

risks. These same concerns likely have weighed on consumer confidence in recent months. As I noted in my testimony, if these uncertainties diminish considerably in the near term, we should be

able to determine whether we are dealing with an economy poised

to grow more rapidly or one that is still laboring to rectify lingering

imbalances.

Q.5. Economists have long lamented the low savings rate of Americans. The President’s budget includes sweeping proposals aimed at

55

raising the amount of money Americans save. I believe that increasing savings is critical yet I am concerned that we may not be

able to go as far as the President suggests. If the Congress chose

to address this issue, how would you recommend that we provide

greater incentives for individual saving?

A.5. I agree that raising our Nation’s saving rate should be an important long-term priority. Saving frees up resources from current

use and thereby makes those resources available for investment in

new plants and equipment. Indeed, about half of the growth in

labor productivity in the United States over long periods can be attributed to capital investment. The more saving our economy generates, the greater our productivity and prosperity.

Raising personal saving—the saving done by households—can be

an important element of raising national saving—the saving done

by the country as a whole. However, it is only one element. National saving is the sum of personal saving, saving by businesses

(that is, retained earnings), and the saving of governments (that is,

budget surpluses less budget deficits). Of the various savings concepts, it is national saving that is most important for determining

our future national standard of living. Thus, it is critical that any

effort to raise personal saving be judged in terms of its efficacy in

raising national saving.

Q.6. The Fed’s most recent Senior Loan Officer Survey of Bank

Lending Practices (January 2003) reported that banks continued to

tighten lending standards and terms for commercial and industrial

(C&I) loans over the past 3 months in fractions similar to those reported in the October survey. In particular, the percentage of domestic banks that reported worsening industry-specific problems

were a reason for tightening rose substantially from 39 percent in

October to 66 percent in January. What is the nature of industryspecific problems? Do you see any particular types of businesses

having difficulty getting credit? On the other hand, few banks reported that they had tightened any terms on credit card loans or

other consumer loans. Should we have any concerns about too

much credit in this area?

A.6. The survey did not ask respondents to comment on particular

industries that were experiencing problems. The few banks that

volunteered such information most commonly cited the energy industry, with the telecommunications and airlines industries also

being mentioned.

The growth of consumer credit slowed sharply last year, to 3.3

percent, down from 6.9 percent in 2001. Part of this slowdown owes

to a substantial volume of debt consolidation facilitated by a wave

of ‘‘cash out’’ refinancing of mortgage debt in an environment of unusually low mortgage rates. Indeed, the growth of mortgage debt

was sufficiently strong to raise the growth of overall household

debt, the sum of consumer credit and residential mortgages, in

2002. Even so, as I mentioned in my testimony, adding in the fixed

costs associated with other financial obligations, such as rental

payments of tenants, consumer installment credit, and auto leases,

the total servicing costs faced by households relative to their incomes are below previous peaks and do not appear to be a significant cause for concern at this time. Recent declines in delinquency

56

rates on total household debt suggest that this sector remains

healthy overall.

Q.7. Last week, we saw American Insurance Group (AIG) increase

its reserves by $3.5 billion—a result of unexpected costs from corporate claims over injury lawsuits, corporate mismanagement, improper financial transactions, and medical malpractice. AIG has a

significant amount of capital and isn’t in financial danger. Can we

expect to see similar increases in reserves for other companies and

what does this mean for the insurance industry’s condition as a

whole? How much of what we are seeing is due to price competition

among insurers versus potential flaws in our tort liability system?

A.7. As you know, the Federal Reserve does not have direct supervisory or regulatory responsibility for the insurance industry. In its

role as umbrella supervisor of financial holding companies, and for

internal purposes, the Federal Reserve tracks broader insurance industry developments, particularly in view of the industry’s role in

providing credit to the economy. The Federal Reserve monitors

insurance industry developments using publicly available information. Our response is limited to comments on the property and casualty sector of the insurance industry in view of your reference to

adverse reserve developments in that sector.

Based on the publicly available sources, it appears that further

adverse reserve developments for a number of property and casualty insurance companies may occur. It is our understanding that

a large proportion of the recent additional claims reserving for the

industry as a whole is associated with business booked in the late

1990’s when pricing was particularly competitive and that additional reserving may be anticipated. The increased reserving

appears to be largely related to losses in commercial coverage,

including coverage for product liability, workers’ compensation,

general liability, financial guarantees, and directors and officers insurance. We also understand that additional reserving by a number

of companies is associated with commercial coverages under general liability dating back to the 1970’s and before, particularly for

asbestos-related claims. (AIG reports that its exposure to asbestos

claims is minimal and attributed none of its increased reserves

noted above to asbestos exposure.)

In addition to continued underwriting losses, other factors may

continue to affect the condition of the property and casualty insurance industry, including declining interest earned on investment

portfolios and write-downs for bond impairments. For many years

prior to 2000, property and casualty insurance companies relied on

their investment portfolio results to offset underwriting losses. Declines in corporate credit quality and equity prices in recent years

have reversed that trend, which has put significant pressure on insurance companies to price their products to cover expected losses

and recover prior losses. The industry now appears to be benefiting

from significantly stronger demand for insurance products and increased insurance premium rates across virtually all business lines,

and may benefit in the future from the heightened focus on underwriting standards.

57

On balance, the industry continues to face significant challenges.

Despite the adverse effect of recent developments on earnings and

capital, capital levels appear strong by historical standards.

The Federal Reserve does not have the data to determine the extent to which the reserve developments may have been attributable

to adverse judgments by juries. Press reports suggest that the adverse reserve developments may be attributed, in large part, to

unsustainable, aggressive pricing during the late 1990’s, but we do

not have the data to indicate the extent to which the reserving is

attributable to competitive pricing.

Q.8. Although the banking industry continues to earn record profits, credit-quality problems continue to be a concern in commercial

and industrial (C&I) loan portfolios at large banks. The industry’s

noncurrent rate on C&I loans increased from 2.87 to 3.01 percent

during the quarter, the first time since the first quarter of 1993

that it has been above 3 percent. Will we see banks continue to add

to loan loss reserves when the fourth quarter data is released? Will

credit quality problems continue into 2003 or can we expect to see

an improvement?

A.8. Bank data for the fourth quarter of 2002 show that both net

charge-offs and nonperforming assets declined moderately from the

previous quarter, providing some indication that credit quality

overall has begun to improve. Broadly speaking, the key contributing factors to the credit quality problems experienced in the past

2 years—a period of recession and weak economic growth, structural problems experienced by certain specific industrial sectors

(e.g. telecommunications) and the revelation of improper

corporate governance practices at certain firms—appear to have

receded in significance. These preliminary indications of improvement should be interpreted with caution. Many bankers have expressed considerable uncertainty about the prospects for significant

improvement in credit quality before the middle of 2003.

Consistent with this general outlook, banks bolstered their reserves in the fourth quarter by about $1.5 billion, so that reserve

coverage of nonaccrual loans improved to 1.63 times, an increase

in the multiple of 0.06 from September 2002. For the full year, a

net increase in reserves of $3.2 billion was not sufficient to offset

more rapid growth in nonaccrual loans, so that reserve coverage of

these loans declined by 0.11 times from year-end 2001.

The noncurrent ratio for C&I loans cited in the question provides

one useful indicator of the severity of credit problems at banks. In

the current period, this indicator has been strongly influenced by

lower C&I loans outstanding that were attributable to cyclically

weak business loan demand, as well as by increases in noncurrent

loans. A broader measure of credit quality, the noncurrent rate for

all loans, reached only 1.45 percent of loans at year-end 2002, well

below the comparable figure of 3.06 percent in 1992. This result is

consistent with the broader view that the current credit cycle has

been much more manageable for banks than that of a decade ago.

The most significant area of difference is in commercial real estate

lending. In 1992, the noncurrent rate for all real estate loans was

3.88 percent while the same rate for construction loans reached a

remarkable 14.01 percent; these ratios were far lower in 2002, at

58

0.89 percent and 0.98 percent, respectively. A number of factors

contributed to the unusually large magnitude of the 1992 figures,

including the poor lending practices and the significant weakness

of commercial real estate as an economic sector at that time.

Q.9. When you appeared before the Committee last July, I asked

a question about productivity. I would like to revisit that issue

again today. Last year, productivity in both the business and nonfarm business sectors rose 4.7 percent—the fastest pace since 1950

and more than four times the 1.1 percent gain posted in 2001.

What are your views regarding this significant gain? What could be

done to attempt to duplicate gains of this magnitude or greater? Do

you think that this significant increase provides any indication as

to the future direction of the economy?

A.9. The impressive performance of productivity recently appears

to support the view that the step-up in the pace of structural productivity growth that occurred in the latter part of the 1990’s has

not, as yet, faltered. Indeed, the high growth of productivity during

the past year merely extends recent experience. Since the mid1990’s, output per hour has been growing at an annual rate of 21⁄2

percent, on average, compared with a rate of roughly 11⁄2 percent

during the preceding two decades.

Arguably, the pickup in productivity growth since 1995 reflects

largely the ongoing incorporation of innovations in computing and

communications technologies into the capital stock and business

practices. In addition to the rapid pace of technical progress, deregulation and other policies to promote the flexibility of the economy have almost surely contributed to the spread and adoption of

innovations that have, in turn, boosted the growth of productivity.

Furthermore, the more flexible is an economy, the greater is its

ability at any given point in time to be producing close to its productive potential.

Looking forward, the transition to the higher permanent level of

productivity associated with previous innovations is likely not yet

completed. The chances of prolonging the period of rapid innovation, doubtless, will be enhanced by maintaining and extending

conditions that contribute to flexibility and by dismantling policies

that contribute to unnecessary rigidity.

However, history does raise some warning flags concerning the

length of time that productivity growth remains elevated. Gains in

productivity remained quite rapid for years after the innovations

that followed the surge in inventions a century ago. But in other

episodes, the period of elevated growth of productivity was shorter.

Regrettably, examples are too few to generalize. Hence, policymakers have no substitute for continued close surveillance of the

evolution of productivity during this current period of significant

innovation.

Q.10. I would like to quote from remarks given by Chairman Alan

Greenspan at Lancaster House, in London, September 25, 2002:

The development of our paradigms of containing risk has emphasized, and will,

of necessity, continue to emphasize dispersion of risk to those willing, and presumably able, to bear it. If risk is properly dispersed, shocks to the overall economic

system will be better absorbed and less likely to create cascading failures that could

threaten financial stability.

59

The broad success of that paradigm seemed to be most evident in the United

States over the past 21⁄2 years. Despite the draining impact of a loss of $8 trillion

of stock market wealth, a sharp contraction in capital investment and, of course, the

tragic events of September 11, 2001, our economy held firm. Importantly, despite

significant losses, no major U.S. financial institution was driven to default. Similar

observations pertain to much of the rest of the world but to a somewhat lesser

extent than to the United States.

In light of these circumstances and observations, plus a significant tax-cutting proposal by our President of an overall estimated

$674 billion dollars, and the likelihood of impending war against

Iraq, what are your thoughts about the U.S. economy’s resilience

for the upcoming year?

A.10. The ability of our economy to weather the many shocks inflicted on it since the spring of 2000 attests to our market system’s

remarkable resilience. As I have noted previously, that characteristic is far more evident today than two or three decades ago.

There may be numerous causes of this increased resilience. Among

them, ongoing efforts to liberalize global trade have added flexibility to many aspects of our economy over time. Furthermore, a

quarter-century of bipartisan deregulation has significantly reduced inflexibilities in our markets for energy, transportation, communication, and financial services. And, of course, the dramatic

gains in information technology have markedly improved the ability of businesses to address festering economic imbalances before

they inflict significant damage. This improved ability has been further facilitated by the increasing willingness of our workers to embrace innovation more generally. Looking forward, the enhanced

flexibility should continue to allow the economy to withstand the

potentially destabilizing effects of additional negative shocks.

Q.11. I share the Chairman’s view regarding the need to keep in

place mechanisms that control spending in the budget process. I

am particularly intrigued by the ideas relating to limits on the ability to have emergency or supplemental spending. It seems that

these types of measures are a significant loophole in the system.

Would you recommend that there be some type of automatic offset

for these types of bills? Would you suggest that a super-majority

(60 votes or more) be required to waive such a rule?

A.11. I recommend that Congress reinstate discretionary spending

caps and PAYGO rules because those procedures have provided

clear direction and constructive goals capable of offsetting in-built

political biases in favor of budget deficits. To remain effective over

time, a budgetary control mechanism must be stringent enough to

exert real budgetary restraint and yet be sufficiently flexible to remain relevant in the face of ‘‘shocks’’ such as wars, recession, or

unforeseen surpluses. Given the recent breakdown of budget controls in the face of emerging surpluses, I agree that closing spending loopholes in a way that better balances flexibility and overall

restraint would be desirable. That said, how to best accomplish

such adjustments must be left with Congress, which has the expertise needed to evaluate how possibly subtle changes in the budget

process might affect budget decisions.

Q.12. Your testimony makes clear that our current cash-based

budget may present a misleading picture of actual Federal Government commitments. I agree with you a better system is needed so

60

that we can get a handle on Federal spending. How would we transition to such a system and over what time period? Should we also

be looking at a capital budget system for certain types of programs

which reflect infrastructure building?

A.12. As I stated in my testimony, an accrual-based accounting system could be constructed with a reasonable amount of effort. Moreover, at least a set of rough estimates of an accrual-based budget

probably could be developed relatively quickly. Although there appear to be no major conceptual hurdles blocking preparation of

more refined estimates, it would not be hard to imagine—given the

vast scope and complexity of the Government’s operations—that

significant operational questions might arise. All of those questions

should be resolvable within a relatively short time-frame. Based on

present information, I would recommend that accrual-based budgetary information be developed as a supplement to—not substitute

for—the current, largely cash-based, unified budget. If that same

view is adopted by the Congress, the transition to production of

accrual-based estimates presumably could proceed on a reasonably

expedited basis.

The capital-budgeting concept has some merit for the Government because it can provide useful information about the way the

Government’s activities are affecting overall saving and investment. However, such information is already provided in the Analytical Perspectives volume of the budget. Moreover, implementing a

separate capital expenditures category within the budget that, presumably, would be subject to different rules than the operating

budget would likely be problematic. In particular, I am concerned

that the classification of spending as between current expenditures

versus capital expenditures could be susceptible to manipulation.

I would also note that there is a fundamental difference between

the application of capital budgeting in the private and Government

sectors. In the private sector, separate accounts for capital expenditures can be justified because capital investments are expected to

yield financial returns that are applied to interest charges and to

liquidate the liability side of the capital accounts as the assets

depreciate. Government investments generally are not expected to

yield comparable financial returns.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED

FROM ALAN GREENSPAN

Q.1. Over the past couple of years we have seen an increasing

number of credit unions drop their Federal insurance and opt for

private insurance. From a safety and soundness perspective, is this

something that we should be concerned with at this time?

A.1. The banking and thrift industries have had unfortunate experience with alternative deposit insurance systems, most recently

during the 1980’s in Ohio and Maryland. Participation in such systems can appear attractive to financial institutions, particularly if

that participation is viewed as reducing the scope and cost of Federal regulatory oversight. In the final analysis, these alternative

systems did not provide adequate oversight of the participating institutions and proved to be insufficiently funded or diversified to

withstand significant failures. The result was mass depositor withVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00064 Fmt 6633 Sfmt 6601 90930.TXT SBANK4 PsN: SBANK4
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drawals from, and ultimately the failure of, other similarly-insured

institutions.

Credit unions have no immunity to these risks, as demonstrated

in the collapse of the Rhode Island Share and Deposit Indemnity

Corporation in 1991. The NCUA has been vocal in expressing its

concern, on a number of occasions, about the potential problems

associated with credit unions opting for private deposit insurance,

including undue relaxation of their field-of-membership rules and

insufficient oversight of the financial condition of these institutions.

The history of alternative deposit-insurance systems suggests that

such concern is well-founded.

Q.2. What impact do you anticipate from regulatory relief legislation that allows interest on business checking accounts to have on

monetary policy and on the economy as a whole? How would it specifically impact small businesses?

A.2. Permitting interest to be paid on business checking accounts

would help to improve the efficiency of our banking industry and

provide important benefits for the business customers of banks. A

more efficient banking industry would strengthen the overall economy by reducing the level of resources needed to provide a given

level of banking services. In addition, interest on business checking

could be beneficial for the implementation of monetary policy in the

future if it were combined with the authorization of interest on balances held at Federal Reserve Banks.

Currently, the prohibitions against interest on demand deposits

and on required reserve balances give banks incentives to establish

programs to sweep the demand deposits of larger business firms

into instruments that can earn interest and that are not subject to

reserve requirements. Banks also set up complicated compensating

balance programs that pay implicit interest through credits for the

use of their services by larger firms. If interest could be paid on

demand deposits and on the reserves that must be held against

them, there would be no need for such programs, and the resources

devoted to them could be redirected to activities that are genuinely

productive for the economy as a whole.

Sweep programs have the potential to undermine the implementation of monetary policy under current operating procedures. The

Federal Open Market Committee determines a target for the Federal funds rate, which the Open Market Desk at the Federal Reserve Bank of New York tries to achieve by adjusting the aggregate

supply of reserves through open market operations. To realize the

desired Federal funds rate, the Desk needs to have a predictable

demand for reserves so it knows the level of reserves to supply. A

predictable demand is provided by balances held at Reserve Banks

to meet reserve requirements and contractual clearing requirements. If these balances were to drop too low, the demand for reserves would be less predictable and the Desk would find it more

difficult to achieve the targeted level of the Federal funds rate. Interest payments on balances at Reserve Banks, along with interest

payments on business checking accounts, would remove incentives

for reserve-avoidance activities, thereby helping to ensure that the

balances held at Reserve Banks remain at a satisfactory level for

the continued effective implementation of monetary policy.

62

While households have been able to earn interest on their checking accounts since the early 1980’s, and larger businesses, at some

cost, have earned implicit interest through sweep programs and

compensating balance arrangements, small businesses continue to

be disadvantaged by the unnecessary prohibition against interest

on demand deposits. The checking accounts of small firms are often

not sizable enough to justify the complicated compensating balance

arrangements or the type of sweep programs mentioned above.

Therefore, many small firms earn no interest on the funds they

keep in demand deposit accounts.

Q.3. What is your position on whether Industrial Loan Companies

should be able to offer interest bearing corporate checking accounts? Do you believe they should be subject to the same regulatory treatment with regards to interest on their accounts?

A.3. Currently, Federal law prohibits commercial firms from owning and operating insured banks and establishes a prudential

framework of supervision that protects the safety and soundness of

banks controlled by corporate owners and thereby protects the taxpayer. When Congress closed the nonbank bank loophole in 1987,

it granted corporate owners of industrial loan companies (ILC’s)

chartered in a limited number of States an exception from the rules

that apply to all other corporate owners of banks. The exception

was subject to the condition that the ILC either refrain from offering demand deposits withdrawable by check or remain below $100

million in assets. At that time, ILC’s were for the most part small

local institutions that did not offer checking accounts and consequently were distinguishable from full service insured banks. In

recent years, the insured deposits in a number of ILC’s have grown

into the multiple billions of dollars and ILC’s have been acquired

by a number of large corporations.

The Board opposes allowing ILC’s that currently cannot offer

demand deposits to offer their functional equivalent: Business

checking accounts. If this were allowed, ILC’s would become the

functional equivalent of full service insured banks. This would turn

the limited exception for ILC’s into a significant competitive advantage for corporate owners of ILC’s, such as large retail and commercial firms, by allowing them to avoid the rules that apply to all

other corporate owners of full service insured banks. Unlike bank

holding companies, corporate owners of ILC’s would be able to have

commercial affiliations and avoid the prudential framework the

Congress has deemed essential for the enhancement of financial

stability and the protection of the taxpayer. Indeed, in the GrammLeach-Bliley Act (GLB Act), the Congress rejected efforts to allow

commercial entities to acquire insured depository institutions and

closed the unitary thrift loophole.

This is not a technical matter, nor a simple matter of fairness

that affects only a small number of grandfathered companies.

There is no restriction that prevents grandfathered States from

chartering new ILC’s for corporations seeking banks, as they have

continued to do since 1987. Moreover, competitive pressures could

encourage existing bank holding companies seeking commercial

affiliations or to avoid prudential supervision to relocate their insured banks to grandfathered States that charter ILC’s to take adVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00066 Fmt 6633 Sfmt 6601 90930.TXT SBANK4 PsN: SBANK4
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vantage of the ILC loophole. Consequently, taking this step would

alter the structure of banking in the United States and be contrary

to two important national policies that Congress reaffirmed recently in the GLB Act: One prohibiting the mixing of banking and

commerce, and the other establishing a Federal prudential framework to assure that companies that own insured banks operate in

a safe and sound manner.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR BUNNING

FROM ALAN GREENSPAN

Q.1. Should the tensions in the Middle East and/or Venezuela continue, are you worried about the effect of long-term high energy

prices on our economy?

A.1. Because the United States is a major net importer of crude oil,

higher crude oil prices exert a restraining influence on the growth

of aggregate demand by a reduction in the purchasing power of

consumers. In addition, higher crude oil prices raise business costs,

and with many companies unable to pass on these cost increases

to their customers, the growth of corporate profits slows; this, in

turn, restrains business investment. Obviously, the higher crude oil

prices go and the longer these high prices persist, the larger the

negative economic consequences.

Q.2. We all know what the housing boom has done for this economy, especially over the last year. Do you see the housing market

being able to sustain this growth?

A.2. Last year was truly extraordinary in terms of the construction

and sale of residential properties. Near-record-low mortgage rates

helped to push up home sales to a record 6.4 million unit pace.

However, unless mortgage interest rates fall by the same extent as

last year, housing construction is likely to contribute less to economic growth in the period ahead.

Q.3. On Thursday, the Joint Tax Committee will release a report

on the Enron mess that I understand may ‘‘name names’’ of those

institutions that aided Enron in trying to evade taxes. Will you be

taking a look at this report to see if it affects institutions under the

Federal Reserve’s regulatory jurisdiction?

A.3. Federal Reserve staff are continuing to evaluate financial

organizations’ participation in the types of structured finance activities that have recently raised significant legal and accounting

questions. These efforts include analysis of individual transactions,

as well as evaluation of the policies and the processes employed by

financial organizations to ensure that they are in compliance with

all laws and regulations. In addition to the information developed

by our own examination efforts, our staff intend to fully consider

information developed by other regulatory agencies, law enforcement offices, Congressional committees, bankruptcy proceedings,

and others. Staff have recently received copies of the Joint Committee’s report and are in the process of reviewing it.

Q.4. Last year, I asked you about your views on OTC energy and

metals trading, and you responded very favorably to the values

that commodity trading brings to the energy industry. Has anyVerDate 11-MAY-2000 07:59 Jan 08, 2004 Jkt 000000 PO 00000 Frm 00067 Fmt 6633 Sfmt 6601 90930.TXT SBANK4 PsN: SBANK4
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thing occurred in the last year to change your support for the OTC

markets?

A.4. I continue to believe that OTC derivatives, including energy

derivatives, are important tools for managing price risks. During

the last year, there have been a string of revelations and accusations regarding the trading practices of Enron and some other

firms during the California energy crisis. However, it is difficult to

determine on the basis of publicly available information whether

the practices in question constituted fraud or market manipulation

or what the scale of any such illegal activity was. What does seem

clear is that most of the practices that are being questioned were

made possible by a flawed implementation of deregulation of energy markets. Fraud and manipulation undermine the integrity of

markets and must be effectively deterred. But, thus far, I have

seen no compelling evidence that it cannot be deterred effectively

through a combination of market discipline and effective exercise

of existing regulatory authority.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR MILLER

FROM ALAN GREENSPAN

Q.1. Morgan Stanley Dean Witter Chief Economist Richard Berner

said on January 10 in The Washington Post, ‘‘Federal budget deficits do tend to raise long-term interest rates, making it more expensive for businesses to borrow and invest. But he added as long

as economic growth is slow, the private sector’s demand for investment money will stay low. Only when the economy significantly

heats up would the competition between the Federal Government

and private companies for lenders significantly boost interest

rates.’’ What do you see the overall economy doing over the next

6 months and do you agree with Mr. Berner’s statement?

A.1. As discussed in the Monetary Policy Report, the members of

the Federal Open Market Committee at the time of my testimony

believed the most likely outcome for the economy this year was

that the economic fundamentals would support a strengthening of

economic growth. Of course, considerable uncertainty attends this

view owing to geopolitical concerns. There is no question that longterm interest rates are affected by rising deficits, and that this

tends to have a negative effect on capital formation. In particular,

econometric evidence suggests that when investors see the projected long-run budget outlook worsening, bond rates rise today in

anticipation of tighter credit market conditions down the road.

Q.2. Mr. Chairman, the housing sector has been one of the strongest performers in our economy. What impact do you see on the

housing sector if deficits increase and interest rates start to rise?

Are we threatening one of our strongest performers?

A.2. Should mortgage interest rates rise, it is entirely possible that

new and existing home sales would decline. It is worth bearing in

mind, however, that any sustained increase in rates presumably

would occur only in the context of a more vigorous upturn in the

pace of business activity, suggesting that the net effect on housing

activity might be relatively limited.

Q.3. Do you see deflation as a threat in the near term?

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A.3. Central bankers have long believed that price stability is conducive to achieving maximum sustainable growth. Historically, debilitating risk premiums have tended to rise with both expected

inflation and deflation, and they have been minimized during conditions of approximate price stability. At present, the United States

is nowhere close to sliding into a pernicious deflation. Indeed, both

market and survey measures of inflation expectations have remained relatively stable over the past year, suggesting that there

are no widespread concerns about deflation developing in the period ahead. But a major objective of the recent heightened scrutiny

of the issue is to ensure that any latent deflationary pressures are

addressed well before they become a problem.

Q.4. Mr. Chairman, last year you and I had the opportunity to discuss OTC energy derivatives. A bill has again been introduced this

Congress that would reverse the legal certainty provisions for OTC

energy derivatives achieved in the Commodity Futures Modernization Act in 2000. My concern is that significant regulatory uncertainty would be created for these products if the bill passes. Have

you seen anything recently that would change your views on the

California energy crisis and whether energy derivatives trading

contributed either to the California energy crisis or to Enron’s

bankruptcy?

A.4. I have not seen anything that demonstrates clearly that energy derivatives trading contributed significantly to the California

energy crisis. The root cause of the crisis was a flawed implementation of the deregulation of energy markets. To be sure, some traders may have used energy derivatives to profit from the flaws in

the regulatory structure. But it remains unclear to what extent

these trading strategies added to the strains and the imbalances

inherent in the regulatory system. Likewise, although Enron was

a leading dealer in energy derivatives, derivatives were not the root

cause of its failure. Rather, it failed because its board of directors

and its auditors allowed it to publish financial statements that distorted its true financial condition and allowed it to become excessively leveraged. More intensive regulation of derivatives would not

have prevented the California energy crisis or the failure of Enron.

Furthermore, as you recognize, some of the proposals for more intensive regulation would have the unintended consequence of reintroducing legal uncertainty regarding contract enforceability.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO

FROM ALAN GREENSPAN

Q.1. During a recent hearing of this Committee, it was suggested

that some financial institutions may be illegally tying the availability or price of credit to investment banking services. What are

your views concerning the adequacy of existing laws and regulation

in this area and are you aware of any convincing evidence that illegal tying occurs? What steps is the Federal Reserve taking to ensure that commercial banking companies do not engage in illegal

antitying activities?

A.1. Banks are subject to a variety of laws that prohibit them from

tying products and services in a manner that harms customers or

lessens competition. Section 106 of the Bank Holding Company Act

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Amendments of 1970, prohibits a bank from extending credit or

varying the terms of credit on the condition that a customer purchase another product or service from the bank or its affiliates,

with certain exceptions. Banks are also subject to the antitying provisions of the Federal antitrust laws, which prohibit a company

with market power in one product from using that market power

to require a customer to purchase a second product.

In addition, to the extent that this conduct involves a bank reducing the price of credit to benefit an affiliate’s investment banking business, it may violate Section 23B of the Federal Reserve Act,

which requires that transactions involving a bank and its affiliate

be on market terms. Finally, in certain circumstances, this practice

may, by reducing the bank’s income for the benefit of an affiliate,

be an unsafe and unsound banking practice.

The Board’s examination procedures and practices include supervisory efforts to ensure compliance with Section 106, other banking

statutes and safe and sound banking practices. For example, the

Board’s Supervision Manuals governing Bank Holding Company

and State Member Bank Examinations provide for compliance reviews of a bank holding company and State member bank that

include evaluation by examiners of the institution’s program for

compliance with Section 106. The Board and the other Federal

banking agencies have also issued guidance directing banks and

bank holding companies to implement and maintain appropriate

systems and controls to promote compliance with the antitying provisions. That guidance addressed the need for specific policies and

procedures addressing tying prohibitions, training materials and

programs that provide examples of prohibited practices and sensitize employees to the concerns raised by tying, compliance systems, and management involvement in reviewing training, audit,

and compliance programs related to tying. See, e.g., FRB Bank

Holding Company Supervision Manual § 3500.0; OCC Insurance

Activities Handbook, Federal Prohibitions on Tying (June 2002);

OCC Bulletin 95–20 (April 14, 1995).

In addition to examining for compliance with this agency guidance, the Board investigates allegations of illegal tying and initiates appropriate actions to remedy any violations of the antitying

provisions that are found. Currently, the Board, in conjunction

with the Office of the Comptroller of the Currency, is conducting

a special targeted review of compliance with the antitying provisions in light of reports described in the press. This review includes

a review of the antitying training and compliance programs, marketing programs, training materials and adequacy of internal audits for compliance with the bank’s internal policies and procedures

at several of the country’s largest banks. These efforts are ongoing,

and we have not yet completed our evaluation of the information

we have gathered thus far. If the Board finds banks offering credit

on an impermissible basis, we will take appropriate supervisory action to assure compliance with the law and to terminate unsafe and

unsound banking practices.

To date, the agencies have not found that commercial banks are

manipulating the pricing of credit to build investment banking

market share. Clearly, banking organizations that have credit relationships with customers hope to sell them the bank’s full range of

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products and services. As you know, banking organizations are permitted to package certain services because some tying arrangements are permissible under statutory and regulatory exceptions

and some customers may request that the bank package services.

In both cases, interested customers have the choice of whether to

enter into these arrangements.

Q.2. Derivatives are complex instruments used by institutional investors. As I understand it, derivatives are actually utilized in our

markets to allocate risk better to those areas or those entities that

can handle it, and it is a stabilizing force in the markets. Do you

agree with that?

A.2. Derivatives allow price risks to be transferred to those most

willing to assume and manage those risks. Provided that those assuming the risks manage them effectively, such risk transfers stabilize markets and contribute to economic growth. Notwithstanding

certain high-profile instances of mismanagement, derivatives have

been an important factor supporting growth of the U.S. economy in

recent years.

Q.3. As you know, last year we had proposals in the Senate that

would amend the CFMA (Commodity Futures Modernization Act).

Do you see any need to revisit the CFMA at this time?

A.3. No. Some may argue that the CFTC needs additional authority to deter fraud and manipulation in the trading of OTC energy

derivatives. While some apparently were tempted to engage in such

market abuses by flaws in the way energy markets were deregulated by the States, the scale and significance of such practices

remains unclear. Furthermore, it is not clear that such practices

cannot be effectively deterred by a combination of market discipline

and exercise of existing regulatory authority. We need to be mindful of the danger of unintended consequences of new legislation,

including the reintroduction of legal uncertainty regarding the enforceability of contracts.

Q.4. What existing reporting and disclosure is made for derivatives

transactions?

A.4. Firms that file financial statements with the SEC are required

to make certain public disclosures related to derivatives transactions. Under generally accepted accounting principles (GAAP) in

the United States, all derivatives must be measured at fair value

and recognized on the balance sheet as either assets or liabilities.

Also, a firm must disclose its objectives for entering into derivatives transactions, the context needed to understand the objectives,

and its strategies for achieving the objectives. In addition, the SEC

requires firms to describe their accounting policies for derivatives

and to provide the quantitative and qualitative information about

market risk exposures, including exposures due to derivatives

transactions.

Banks are subject to additional public reporting requirements for

derivatives transactions. Regulatory reports for banks and bank

holding companies require a breakdown of derivatives transactions

by risk factor (interest rate, foreign exchange, equity, commodity,

credit) by type (futures, forwards, options), and by purpose (trading

or nontrading). Moreover, the Federal Reserve has encouraged

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large banks to disclose additional information on market risk exposures in the trading account (exposures arising from derivatives

and other trading instruments), such as value-at-risk on an aggregate basis and value-at-risk by risk factor.

RESPONSE TO WRITTEN QUESTIONS OF SENATOR SARBANES

FROM ALAN GREENSPAN

Q.1. Chairman Greenspan, at the hearing you stated that, ‘‘There

was a good deal of concern, as you know, about this housing bubble. But our evaluation of the data and the outlook suggests that,

while obviously, there are potential problems, they are not serious

ones that need to be addressed in any material way as far as we

can judge.’’ Can you please elaborate on these potential problems

and the process that led you to your conclusion that they are not

serious enough to be addressed in any material way?

A.1. The house price increases over the past 2 years have been described by some analysts as possibly symptomatic of an emerging

housing bubble, not unlike the stock market bubble whose bursting

has produced considerable distress in recent years. Existing home

prices (as measured by the repeat-sales index) rose by 7 percent

during 2002, and by a third during the past 4 years. Such a pace

cannot reasonably be expected to be maintained. And recently,

price increases have slowed.

It is, of course, possible for home prices to fall as they did in a

couple of quarters in 1990. But any analogy to stock market pricing

behavior and bubbles is a rather large stretch. First, to sell a home,

one almost invariably must move out and in the process confront

substantial transaction costs in the form of brokerage fees and

taxes. These transaction costs greatly discourage the type of buying

and selling frenzy that often characterizes bubbles in financial

markets.

Second, there is no national housing market in the United

States. Local conditions dominate, even though mortgage interest

rates are similar throughout the country. Home prices in Portland,

Maine, do not arbitrage those in Portland, Oregon. Thus, any bubbles that might emerge would tend to be local, not national, in

scope.

Third, there is little indication of a supply overhang in newly

constructed homes. The level of overall new home construction, including manufactured homes, appears to be well supported by

steady household formation and not dependent on high and variable replacement needs or second-home demand. Census Bureau

data suggest that one-third to one-half of new household formations in recent years result directly from immigration.

After their very substantial run-up in recent years, home prices

could recede. A sharp decline, the consequences of a bursting bubble, however, seems most unlikely. Nonetheless, even modestly declining home prices would reduce the level of unrealized capital

gains and presumably dampen the pace of home equity extraction.

Home mortgage cash-outs and home equity loan expansion would

likely decline in the face of declining home prices. However, the 5-

year-old home building and mortgage finance boom is less likely to

be defused by declining home prices than by rising mortgage interest rates.

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Should rates rise, it is entirely possible that new and existing

home sales would decline. However, it is worth bearing in mind

that any sustained increase in rates presumably would occur only

in the context of a more vigorous upturn in the pace of business

activity, suggesting that the net effect on housing activity might be

relatively limited.

Q.2. In the Administration’s proposed budget they have decreased

their projections for the cost of bank failures in fiscal year 2004 by

70 percent (from $6.4 billion to $1.9 billion). Do you agree with the

Administration’s changed projection? Comparing the economic environment for banking institutions, going forward from this year

compared to last year, would you expect the likelihood for aggregate bank failures to have increased, decreased, or remained the

same?

A.2. Bank failures have been relatively few in recent years, and

only 10 banks and one thrift failed in 2002. Based upon current

conditions, there are no indications that failures should be expected

to rise significantly in the near future. Despite recent increases in

problem loans and charge-offs, the number and size of problem

banks remains small relative to the banking industry. The FDIC

reported that at year-end 2002 there were 136 problem institutions

(for example, those receiving a CAMEL composite rating of ‘‘4’’ or

‘‘5,’’ made up of 116 banks and 20 thrifts), with combined assets of

approximately $39 billion. These figures are significantly higher

than just a few years ago, but nonetheless represent a relatively

minor share of the industry. Moreover, the industry once again reported robust earnings for the year 2002 and remains strongly capitalized. The prospect of improved economic conditions, together

with preliminary indications that problem loans have begun to decline, suggest that credit quality pressures on the banking industry

may be expected to subside in the coming years. Barring unforeseen developments, it would be reasonable to expect that the number of bank failures in the next 2 years would remain low, perhaps

even lower than were experienced in 2002.

Neither figure cited in the question as projected costs of bank

failures could readily be located in the Administration’s budget documents, so that it is not possible to comment on them specifically.

As a general observation, both figures seem very high. The total

costs to the deposit insurance funds from bank failures have been

below $1 billion every year since 1992, even if losses to both the

Bank Insurance Fund and Savings Association Insurance Fund are

included. Estimated losses for 2002 came to roughly $630 million.

Given the current number and size of problem banks and the general state of the banking industry, and barring significant unforeseen events, it would seem reasonable to expect annual losses to

be well below even the $1.9 billion figure in the next 2 years.

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